Investment Decisions of Nonprofit Firms: Evidence from Hospitals

Manuel Adelino
Duke University’s Fuqua School of Business
manuel.adelino@duke.edu

Katharina Lewellen Tuck

School at Dartmouth
k.lewellen@dartmouth.edu

Anant Sundaram
Tuck School at Dartmouth
anant.sundaram@dartmouth.edu

First draft: February 2012

Current draft: October 2013

We thank Chuck McLean and Arthur Schmidt of the GuideStar USA for their extensive help in providing the data. The
paper greatly benefited from conversations with Robin F. Kilfeather-Mackey, Gary Husband, and Peter Martin of
Dartmouth-Hitchcock, Dianne Ingalls and Scott Frew of Dartmouth College, Michael Pagliaro and Nikki Kraus of Hirtle,
Callaghan, & Co, Rick Steele of Longmeadow Capital, LLC., and Diane Daych of Marwood Group. We also thank seminar
participants at Dartmouth College, University of Pittsburgh, and University of Washington, Heitor Almeida, Andrew
Bernard, Ken French, Robert Hansen, Leonid Kogan, Joshua Schwartzstein, and Jonathan Skinner for their helpful
comments and suggestions.
 Abstract

More than 20% of U.S. firms are nonprofit, yet this organizational form has received little attention in
corporate finance. This paper takes a step towards closing this gap by examining investment choices of
nonprofit hospitals. Most hospitals hold large financial assets, and hospital-specific shocks to the
performance of these assets are likely unrelated to investment opportunities. We use this setting to test
how shocks to cash flows affect hospital investment. We find that capital expenditures increase, on average,
by 10-28 cents for every dollar received from financial assets. The sensitivity is similar to that found earlier
for shareholder owned corporations, and it is driven by spending on buildings and medical equipment. We
do not find that hospital executives are significantly “paid for luck”, or that spending on salaries of other
personnel and perks responds significantly to cash flow shocks. Hospitals with an apparent tendency to
overspend on medical procedures do not exhibit higher investment-cash flow sensitivities than otherwise
comparable hospitals. However, the sensitivities are higher for hospitals that appear financially constrained.

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1 Introduction

More than 20 percent of U.S. corporations are nonprofit entities, yet this organizational form has
received almost no attention in corporate finance. Nonprofits dominate the healthcare space, which
constitutes more than 15% of the U.S. economy (Philipson and Poser (2006)) and has been at the center
of intense political debate. Hospitals are part of this debate as they account for about 30 percent of all
expenditures in healthcare. 1 However, understanding investment decisions of a nonprofit hospital is
challenging because standard finance theories and most empirical research deal primarily with shareholder
owned corporations, and their insights are not necessarily applicable to nonprofits.

Nonprofits differ from for-profits in fundamental ways. While the objective function of a for-profit
(in the absence of frictions) is to maximize shareholder value, nonprofits do not have shareholders, and
their stated objectives include serving donors, community, or the society at large (Hansmann (1980), Sloan
(2000)). As a result, nonprofits might evaluate and select investment projects differently than forprofits do,
even in the absence of agency problems or other frictions. The potential for agency conflicts adds another
dimension that sets the two types of firms apart. Donors and taxpayers have at best weak (or no) control
over their firms’ internal decision making and the literature often assumes that nonprofits’ objectives are
best approximated as maximizing insiders’ rather than donors’ or taxpayers’ utility (Feldstein (1971), Pauly
and Redisch (1973), Glaeser (2003)). This suggests that nonprofit firms are not in close proximity to for-
profits on the governance spectrum, and that understanding these firms is important not only because of
their economic significance, but also because they offer a setting in which the effects of weak governance
on firm behavior may be most apparent.

This paper takes a step towards a better understanding of how nonprofit hospitals invest. Our
framework builds on a long tradition of finance research on corporate investment. The central question in
this literature is whether firms’ investment choices are efficient and to what extent they are distorted by
governance problems and financing constraints. 2 The standard approach to identify the effects of
governance or financing frictions on investment has been to focus on the sensitivity of investment to cash
flows. This framework relies on a prediction from Q theory that cash flow shocks that are unrelated to a
firm’s investment opportunities should have no impact on investment. Using this insight, researchers have

1 CMS National Health Expenditure Projections for 2009 (http://www.cms.gov/Research-Statistics-Data-

andSystems/Statistics-Trends-and-Reports/NationalHealthExpendData/downloads/proj2009.pdf).
2 These arguments are discussed, for example, in Easily and O’Hara (1983), Fama and Jensen (1985), Glaeser and Shleifer

(2001), and Fisman and Hubbard (2005).

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interpreted the observed investment-cash flow sensitivity as evidence of free-cash flow problems or
financing constraints.

This paper extends this literature in three ways. First, our analysis focuses on the nonprofit healthcare
sector which, as we argue above, has been largely neglected in corporate finance despite its economic
importance. Second, we use returns from endowments as a novel source of variation for identifying the
causal effect of cash flows on investment. This helps us address one of the key difficulties in this literature,
namely that of identifying shocks to cash flows that are unrelated to investment opportunities (e.g.,
Gilchrist and Himmelberg (1995), Kaplan and Zingales (1997), Erickson and Whited

(2000), Blanchard, Lopez-de-Silanes and Shleifer (1994), Lamont (1997), Moyen (2004), Rauh (2006),
Bakke and Whited (2011)).3 Third, we use unique data on hospital (over)spending on medical procedures
to study the mechanisms that drive investment-cash flow sensitivities in nonprofit firms, and possibly in
corporations at large. The two most common explanations–financing constraints and agency conflicts– are
fundamentally different but are difficult to distinguish empirically (Stein (2003)).4

Hospitals offer an attractive setting to study the link between investment and cash flows. One reason
is that nonprofit hospitals are exposed to significant exogenous and measurable cash flow shocks because
these firms–in contrast to most corporations–own large financial assets in the form of endowments. Gains
and losses from these financial assets make up a large fraction of hospital profits and have the potential to
affect capital and other expenditures. Importantly, cross-sectional variation in returns on these assets is
unlikely to be correlated with hospitals’ investment opportunities or with any other aspect of a hospital’s
production function. This allows us to use returns on financial portfolios to measure the impact of cash
flow shocks on various types of expenditures.

Another advantage of this setting is that hospitals publish detailed information on their capital
investments and spending. In order to receive Medicare funding, each hospital must provide detailed cost
reports on different types of capital spending, including expenditure on major hospital equipment (such as

3 The literature has also questioned some of the assumptions of the Q theory, pointing out that the presence of
monopoly power or the absence of adjustment costs would affect its implications for how investment should respond to
cash flows (e.g., Gomes (2001), Alti (2003), Abel and Eberly (2011)).
4 Hadlock (1998) shows that the sensitivity of investment to total cash flows (i.e., accounting profits plus depreciation)

varies non-monotonically with insider ownership, consistent with agency explanations (see also Pawlina and Renneboog
(2005) and Degryse and De Jong (2006)). Hoshi, Kashyap, and Scharfstein (1991) show that Japanese firms with strong
ties to banks exhibit lower sensitivities, pointing to both agency conflicts and financing constraints. Lewellen and Lewellen
(2012) show, after accounting for measurement error in Q, that even firms that appear unconstrained exhibit positive
investment-cash flow sensitivities, which also suggests the importance of free-cash flow problems.

3
CT scans, MRIs, and other major surgical and diagnostic equipment), buildings, and minor equipment
(such as surgical instruments). In addition, in annual filings with the Internal Revenue Service hospitals
report other types of expenditures, including executive salaries and travel and conference expenses. We
combine these different data sources to obtain a detailed picture of the types of expenditures that respond
to cash flow shocks.

Finally, spending by hospitals has been the subject of a large literature in healthcare economics, and
extensive research focuses specifically on identifying and measuring “excessive spending”. The term
captures the idea that some hospitals spend more on medical treatment than is optimal from the viewpoint
of their residual claimants, and in particular the communities they serve (see review in Skinner (2012)). The
insights from this research allow us to explore the role of overspending as an explanation for investment-
cash flow sensitivity, which is an opportunity rarely available in other contexts. One influential approach
to identify overspending has been to measure hospital-specific attitudes to treatment at the end of patients’
lives, including the use of life sustaining treatment, chemotherapy, or surgical interventions. Following this
approach, we explore how hospitals’ medical spending relates to their investment patterns, and in particular
how hospitals with different spending philosophies invest in financially good and bad times.

We start our empirical analysis by establishing the baseline estimate of how capital expenditures of
nonprofit hospitals respond to cash flow shocks. We find that hospitals invest, on average, 10 cents more
in a given year for every additional dollar returned by investment securities in the previous year. This impact
is magnified to 23-28 cents for every dollar when we consider capital expenditures over two years following
the return on financial investments. These estimates are substantially higher than the sensitivities implied
by formal spending rules used internally by nonprofit organizations.5 Interestingly, however, the estimates
are similar to those found in prior studies for shareholder owned–and arguably better governed–
corporations (e.g., Gilchrist and Himmelberg (1995), Cleary (1999), Rauh (2006), and Lewellen and
Lewellen (2012)). These findings have two potential implications. They suggest that either investment-cash
flow sensitivities are invariant to large shifts in governance quality (which one might expect when moving

5The rules can be viewed as a nonprofit’s internal governance mechanism. They determine the amount of funds that can
be taken out from an endowment for spending each year, and the amount is typically a percentage of the organization’s
endowment. The actual spending in any given year can be either higher or lower than the amount implied by the
spending rule. For example, a nonprofit can save the appropriated amount or finance its investment from
nonendowment sources.

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from the for-profit to the nonprofit sector), or that nonprofit hospitals’ governance structures are as
effective as those of shareholder-owned firms.

The remaining tests focus on gaining a better understanding of the mechanism driving the investment-
cash flow sensitivities. We follow the previous literature in considering financing constraints and agency
problems–and specifically, overspending by hospital insiders–as the two key alternative explanations. To
examine the effect of constraints, we follow the standard approach in the literature and divide the sample
into groups of hospitals that appear more or less severely constrained based on their levels of debt and
financial assets.6 Kaplan and Zingales (1997, 2000) show analytically that although constraints should affect
investment-cash flow sensitivities, the relation between the degree of constraints and sensitivity may be
non-monotonic. We find that in our sample, more severe ex-ante constraints are associated with a stronger
responsiveness of investment to cash flows. For example, hospitals with above median constraints–when
constraints are measured as net debt or net debt minus financial investments in proportion to net fixed
assets–spend 14-30 cents more per dollar of cash flows than those with below median constraints.

The importance of free cash flow problems as an explanation for investment-cash flow sensitivity has
received less attention in the literature, likely because an ex-ante tendency to overspend is more difficult
for researchers to measure (Stein (2003)). We attempt to shed light on this explanation in two ways. Our
first approach is to examine categories of expenditures that might be especially prone to excessive spending
in a nonprofit firm, such as executive salaries, total salaries, or travel and conference expenses. We find
little evidence that hospitals increase these expenditures when their financial assets do well. For example,
we do not find that hospital executives are “paid for luck” (at least not significantly so), contrary to findings
in Bertrand and Mullainathan (2001) for for-profit firms. In a similar spirit, we examine investment
spending on equipment vs. buildings and land. Glaeser (2003) and others argue that spending on smaller
ticket items with potential private benefits to doctors–such as medical equipment– might be particularly
susceptible to overspending. Our tests show a similar sensitivity of spending on equipment per dollar of
cash flows as that of spending on buildings. To the extent that doctors indeed prefer one category of
expenditures over the other, overall these tests provide little support for the view that insiders’ spending
of free cash flow on perks or favored projects is responsible for the investmentcash flow sensitivities we
observe.

6 These tests are similar in spirit to those in Fazzari, Hubbard and Petersen (1988), Almeida, Campello and Weisbach
(2004), and Rauh (2006), among others, in the context of corporations.

5
 Our second approach follows research in healthcare economics that focuses on identifying hospitals
with an ex-ante tendency to overspend on medical treatment relative to patient need. The approach relies
on measuring the intensity with which different hospitals treat severely ill patients at the end of their lives.
Consistent with the previous tests, we find no evidence that high-intensity hospitals increase investment
more strongly when their cash flow is unexpectedly high. In fact, our tests reveal the opposite pattern:
investment-cash flow sensitivities are significantly higher for hospitals with abnormally low intensity rates,
especially when these hospitals also have high levels of debt. These results reinforce our earlier finding
pointing to financing constraints as a key explanation for the investment-cash flow sensitivities
documented in Table 3.

The final contribution of this paper is to explore how direct government oversight interacts with
hospitals’ propensity to change their investment plans in response to financial performance. To do so, we
use the fact that some hospital investments are subject to government regulation and that the degree and
nature of this regulation varies by state. Specifically, 36 states require hospitals to obtain state approval for
major investment projects as part of their Certificate of Need (CON) laws. Prior literature finds no
conclusive evidence that CON laws affect the level of hospital investment (see survey by Conover and
Sloan (1989)). Our tests reveal that investment in regulated states is significantly less responsive to cash
flow shocks. If interpreted causally, this finding suggests that regulation smoothes investment across
financially good and bad times.

Other than in the context of the CON laws, empirical research on nonprofit investment has been
scarce, with only two (to our knowledge) published papers examining it directly. Wedig, Hassan, and Sloan
(1989) investigate the link between hospitals’ reimbursement methods and their entry and exit decisions,
and Calem and Rizzo (1995) examine the relation between operating cash flows and hospital investment.
However, there has been a growing interest in the financial aspects of nonprofits in recent years. For
example, Lerner, Schoar, and Wang (2008) analyze financial performance of university endowments, and
Brown, Dimmock, Kang and Weisbenner (2013) show that universities change endowment payouts in
response to financial market shocks. Goetzmann and Oster (2012) study how competition between
universities affects endowment allocation into alternative investment classes. Gilbert and Hrdlicka (2013)
study universities’ objective functions and how insiders and outsiders interests affect endowment size.
Finally, Dranove, Garthwaite and Ody (2013) show that the 2008 shock to endowments did not affect
hospital prices but–consistent with our findings–did affect the adoption of health information technology.
A large empirical literature investigates other aspects of hospitals’ behavior, including pricing, costs,
quality of care, and the supply of uncompensated care (see, for example, Malani, Philipson, and Guy (2003)

6
for a review of this literature). A paper most related to ours by Duggan (2000) investigates how California
hospitals responded to the 1990 increase in government subsidies to treat low-income patients. He finds
that both for-profit and nonprofit hospitals responded strongly to these incentives by changing their
patient mix, and that the proceeds from the subsidies appeared to have been saved rather than invested in
physical assets. The response was similar for for-profit and nonprofit hospitals.

The paper proceeds as follows. Section 2 describes existing models of nonprofits and their
implications for investment. Section 3 discusses how spending of nonprofits’ financial income is regulated.
Section 4 describes data and sample selection, and Section 5 presents the main evidence on investment-
cash flow sensitivities. Section 6 examines how sensitivities depend on a hospital’s attitude to spending,
and Section 7 analyzes the effect of hospital regulation. Finally, Section 8 concludes.

2 Nonprofit Firms: Defining Features and Theories of Nonprofit Behavior

2.1 Defining Features of a Nonprofit Firm

The defining characteristic of a nonprofit firm is that it is prohibited from distributing its profits to the
individuals who control it. This requirement is often referred to as the “nondistribution constraint”
(Hansmann (1980). In principle, a nonprofit’s surplus belongs to the community it serves, though nonprofit
firms are not legally required to define who this is (Sloan (2000)).7 As a consequence of the nondistribution
constraint, nonprofits do not have owners (that is, agents with both cash flow and control rights), which
makes this organizational form fundamentally different from for-profits. Though nonprofits have boards
of directors, these boards are usually self-perpetuating, and their objectives are less clearly defined
(compared to for-profit boards whose focus is on shareholder value). 8 The nonprofits’ external
governance entails oversight by the state attorneys general and by the Internal Revenue Service (IRS). The
IRS monitors the firms’ eligibility for tax exempt status, and it also requires that nonprofits disclose publicly
(in their annual Form 990 filings) their operating activities, financial statements, and governance practices.

7 The question of who owns the surplus becomes pertinent when nonprofit hospitals are being acquired by for-profits.
Leone, Van Horn, and Wedig (2004) report that proceeds from hospital acquisitions are usually used to create charitable
foundations to serve “charitable purposes in the community, such as the general promotion of health” (p.114).
8 As part of their fiduciary duties, nonprofit boards must adhere to their organizations’ mission. However, interpreting a

nonprofit’s mission can be difficult, especially if it involves conflicting goals or diverse constituencies (see, e.g., Hazen
and Hazen (2012)).

7
Eligible nonprofits enjoy an exemption from corporate income taxes and property taxes, access to tax-
exempt bond financing, and the right to obtain private donations.

2.2 Theories of a nonprofit firm and their implications for investment

In this section, we summarize the theories of a nonprofit firm developed in prior literature and discuss
their implications for nonprofit investment, especially for how investment should respond to cash flow
shocks. If nonprofits simply maximize present value of future cashflows in spite of their different legal
structures, the standard implications of the Q-theory should apply directly to this group. Our focus in this
section is on the potential deviations from this model. We begin with a frictionless model of a nonprofit–
analogous to the Q-theory for for-profits–in which the firm’s objective is to maximize the utility of its
donors, their local community or the society at large. This view of a nonprofit abstracts from conflicts of
interest between the donors (or the public) and the insiders, and thus provides a starting point for thinking
about nonprofit investment. Most of the literature on nonprofits emphasizes deviations from this
benchmark, however, and argues that these conflicts of interest are severe and that nonprofit insiders
exercise a high degree of control over their firms. These theories– summarized in Section 2.2.2–imply that
nonprofits’ investment should reflect the preferences of their insiders.

2.2.1 Frictionless Benchmark: Nonprofits Acting in the Interest of Donors or the Community at Large

The altruism-based model of a nonprofit has been discussed, for example, in Fama and Jensen (1985),
Rose-Ackerman (1996), and Fisman and Hubbard (2005). A common assumption is that altruistic agents
derive utility from providing certain goods or services to others and are thus willing to subsidize firms
specializing in the production of these goods. To survive, such firms must attract donations or subsidies,
so their choices are guided by the preferences of the providers of these funds (such as donors or the
community). To capture this idea, the models assume that the objective function of a nonprofit firm is to
maximize the utility of its donors. In line with the existing literature, the discussion below centers on
donors, but the term donation can be equivalently thought of more broadly as denoting any type of subsidy
to the nonprofit.9

The altruism framework provides a useful frictionless benchmark that is analogous to the Q-theory for
for-profit firms. We highlight its implications in a simple example described in Appendix A. The main

9 This broader interpretation is especially relevant for nonprofit hospitals, given that current donations represent a small
fraction of overall hospital budgets each year (Glaeser (2003)).

8
insight is analogous to that of the Q-theory in that, without frictions, investment-cash flow sensitivity of
nonprofit firms should be close to zero. The intuition for this result is simple. If the donor derives utility
from charity and other (non-charity) consumption, a shock to the nonprofit’s internal cash flows affects
his/her wealth as it changes the total amount of funds available for consumption. In a frictionless world,
the donor can substitute charity for non-charity consumption by reducing current or future funds to the
nonprofit. Similarly, the donor can substitute current for future charity consumption by investing in capital
markets. As long as consumption of the good produced by the nonprofit that experienced the cash flow
shock is a small fraction of the donor’s overall consumption, a one-dollar shock to the nonprofit’s cash
flows will have an insignificant effect on the nonprofit’s optimal output and expenditures (in the appendix,
we derive conditions under which the sensitivity is exactly zero). 10

Moving away from the frictionless benchmark, it is interesting to consider the effects of the
nondistribution constraint on hospital spending. In the presence of a binding constraint, the nonprofit is
unable to pay out excess cash to donors. Thus, a positive cash flow shock experienced by a nonprofit may
shift the donor’s optimal consumption towards hospital charity (relative to what it would be without the
non-distribution constraint). However, donors may be able to scale back future donations in response to
nonprofit cash flow shocks, so that some of the cash flow can still be used towards spending on other
goods. Moreover, if donors prefer to smooth charity consumption over time, they will require that
nonprofits save some of the unexpected cash flow for future spending so that current spending would be
less affected.

In Section 5.3.1, we use the nonprofits’ internal spending rules to approximate investment-cash flow
sensitivities that might be required by donors in the presence of nondistribution constraints. These rules
are put in place by nonprofit boards, and in some cases directly by donors, and they determine the amount
of funds that nonprofits can take out from endowments for spending each year. The rules provide a useful
benchmark in our context because they link nonprofits’ targeted expenditures to the past performance of
their endowments.

2.2.2 Nonprofits Acting in the Interest of Their Insiders

10The assumption that charitable giving to a particular hospital represents a small fraction of donors’ overall consumption
seems to fit well in our setting, and Glaser and Shleifer (2001) and Fisman and Hubbard (2005) make similar assumptions
in their models of nonprofits. For example, Andreoni (2006) shows that, as of 1995, families spent somewhere between
1.3 percent and 3 percent of household income on charitable donations, and the percentage spent on hospital-related
charitable giving is likely much smaller. This conclusion is similar when we interpret donations broadly as including any
subsidies provided to hospitals by taxpayers. For example, in 2011, the cost of uncompensated care by U.S. hospitals was
estimated to be $41 billion, implying that per-household hospital subsidies represented 0.65% of a median household
income (see American Hospital Association, “Uncompensated Hospital Care Cost Fact Sheet”, January 2013).

9
 The discussion above abstracts from conflicts of interest between nonprofit insiders (managers and
employees) and outsiders such as donors, the local community, or the society at large. Much of the existing
literature on nonprofits argues that these conflicts of interest are potentially severe, suggesting higher
investment-cash flow sensitivities than those targeted by taxpayers or donors.

Many authors take the view that nonprofit insiders are subject to much less scrutiny that corporate
managers. The discipline imposed by the past and the potential donors is weak and leaves substantial room
for insider discretion (Fisman and Hubbard (2005)). Consistent with this perspective, Newhouse (1970)
assumes that nonprofit hospitals maximize the quantity and the quality of their services subject to a zero-
profit constraint (see also Feldstein (1971)). This is because quantity and quality increase the prestige of
hospital trustees, administrators, and doctors. Pauly and Redisch (1973) model the hospital as a physician’s
cooperative where physicians or the hospital staff enjoy de facto full control of the organization. Profits
enter the hospital’s objective function through the budget constraint.

Similarly, Glaeser (2003) argues that nonprofits’ managers have “an unmatched degree of autonomy”
over their firms, and that they are likely to cater to their most influential workers, such as doctors in the
case of hospitals. He describes the evolution of hospitals from donor-driven charitable institutions of the
19th century to mostly doctor-controlled organizations of the 1980s, but argues that the power of doctors
may have eroded more recently because of the increased competitive pressures in the industry.11 Chang
and Jacobson (2010) argue that the evidence from a large exogenous shock to hospitals’ fixed costs is most
consistent with a view of hospitals as perquisite maximizers.

Easily and O’Hara (1983) and Glaeser and Shleifer (2001) and others show that nonprofits may be the
optimal organizational form in spite of these potentially significant agency conflicts. Specifically, in
industries in which customers have a hard time judging product quality (or cannot easily punish firms for
poor quality), shareholder owned firms may have incentives to shirk on quality to increase profits. The
nonprofit’s nondistribution constraint is a way to diminish these incentives and improve product quality.
The undesirable consequence of the constraint is, however, that nonprofits do not have owners and are,

11One important change occurred in 1983 when Medicare changed the way it reimbursed providers for their services.
Specifically, Medicare switched from reimbursing providers on a cost-plus basis (that is, paying for costs plus a certain
percentage) to paying fixed prices per patient based on the so-called “diagnostic related group” (DRG) determined
primarily by the diagnosis and the severity of the case. Another important development was the emergence of the Health
Maintenance Organizations (HMOs) which replaced the traditional forms of insurance and put additional pressure of
hospitals to reduce prices. (Glaeser (2003), p. 27).

10
thus, fully controlled by managers. Since managers cannot divert profits directly, they resort to implicit
payouts such as salary increases and perks.12

A direct implication of this literature in our context is that investment decisions of nonprofit firms
should reflect, in part, the weaker governance structure of these firms. This is the typical free cash flow
problem that has been discussed in the investment-cash flow sensitivity literature. If excessive spending is
more difficult to finance from external sources, the observed investment-cash flow sensitivities of
nonprofit firms should be large and significant, and they should be higher than for better-governed
forprofit firms.

3 Legal Rules Governing the Use of Investment Income in Nonprofits

Our tests focus on how nonprofit hospitals spend income from their financial investments, and this
section describes how this spending is regulated. Financial investments of nonprofits can be broadly
divided into funds that can be used without any limitations by management, and funds that have some type
of restrictions as to their use (usually referred to as “endowment” funds).13 These restrictions are put in
place by the donors at the time of the donation and the state attorneys general monitor the adherence of
the organizations to these rules.

The restrictions usually specify that the donated funds be held in perpetuity by the nonprofit (in the
case of “permanently restricted” funds), or they limit the use of these funds to a certain purpose or for a
pre-determined period of time (in the case of “temporarily restricted” funds). The restrictions typically
apply only to the original principal amount of the donation. The use of income earned from those
investments is governed by the Uniform Prudent Management of Institutional Funds Act (UPMIFA)
which, as of June of 2011, had been adopted by all 50 states.14 This act sets guidelines regarding what is
considered a “prudent” amount of endowment funds that can be appropriated for expenditures. The

12 Arrow (1963) argues that the healthcare sector is particularly prone to product-related information problems because of
the nature of its output: medical advice is highly complex, its quality is difficult for patients to assess, even ex post, and
bad advice can be prohibitively costly. As a result, the softer incentives inherent to nonprofit firms may deliver socially
better outcomes. Hansmann (1980) points out, however, that information problems may be less severe in the hospital
sector than in healthcare overall, and that private and public subsidies to hospitals may have contributed to the importance
of nonprofits in this sector. Both authors emphasize the prominent role of insiders in nonprofit firms, and the potential
distortions such power implies.
13 The equivalent to shareholders’ equity in nonprofit corporations is usually referred to as “Net Assets”, and this account

is subdivided into restricted, temporarily restricted and unrestricted net assets. While there is a relation between restricted
and temporarily restricted financial investments and the equivalent net asset accounts, our discussion here focuses on the
classification of financial assets, i.e. it refers to the left-hand side of the balance sheet.
14 In some cases, donors also specify a desired use for income earned from investments, in which case the restrictions

apply to both the original principal amount, as well as to any income received from the assets (see Ruppel (2002) for a
more complete discussion).

11
current law replaces its predecessor–the Uniform Management of Institutional Funds Act (UMIFA)–that
was in effect from 1972 to 2006 and that covers the years in our sample. Below we describe the provisions
included in both acts to highlight what is and what is not required by the law.

The state-level regulations are relevant to our paper to the extent that they affect the investment policy
of nonprofits or their ability to spend income derived from their endowments. With respect to investment
policies, the law leaves ample space for the nonprofits to make asset allocation decisions. The prudence
standard in the current law simply includes “the duty of care, the duty to minimize costs, and the duty to
investigate” when making investments, so it makes no specific recommendations in terms of asset classes
or maturity of the investments. The previous act (which covers the years in our sample) put even fewer
constraints on the allocation decisions of nonprofits (Gary (2007)).

Regarding the spending of income from financial investments, the UMIFA (that covers the period of
our sample) put one important constraint on nonprofits. They were not allowed to appropriate for
spending any income while the endowment was “underwater”, i.e., whenever the market value of the
endowment was below the dollar amount of the original gift (“historic dollar value”). Some nonprofits
interpreted this provision as limiting only their ability to spend gains on investments, while others in this
situation did not spend any form of income, including dividends and interest (National Conference of
Commissioners on Uniform State Laws (2006)). There were no other notable restrictions on spending
income derived from investments in UMIFA, including no suggested spending caps or floors (“spending
rules”). The more recent UPMIFA removed the restriction on spending income when an endowment fund
is underwater, but it added a “presumption of imprudence” clause which states that spending over seven
percent of the three-year rolling average value of an endowment fund in a single year would be considered
imprudent by the state. There was no such clause in place during our sample period.

As discussed in Section 2, in addition to the state laws it is common for nonprofit organizations to
adopt internal spending rules as part of their self-imposed governance mechanisms. For example, for
universities and colleges, the NACUBO-Commonfound study of Endowments 2010 survey finds that the
majority of the surveyed organizations have spending rules expressed as a percentage of the moving average
value of their endowment funds.15 The rules determine the amount of funds that an organization is allowed
to appropriate for spending from its endowment in a given year. A more detailed discussion of these
internal spending rules and how they relate to our results is in Section 5.3.1.

15NACUBO is the National Association of College and University Business Officers and their publications are available
on http://www.nacubo.org/.

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4 Sample and data

4.1 Data sources

Our main dataset on nonprofit hospitals comes from IRS filings by tax-exempt nonprofit organizations
referred to as Form 990. The filing is required annually from most organizations exempt from federal taxes,
and it contains detailed information on each organization’s finances, mission, and programs.16 The main
dataset was provided to us by GuideStar USA Inc., an information service on U.S. nonprofits. The
Guidestar dataset includes financial statement items from Form 990 for all Hospitals and Primary Medical
Care Facilities as classified by the National Center for Charitable Statistics from 1999 through 2006.17 We
supplement it with hand-collected information on unrealized gains and losses from investments in
securities, which is reported in the attachment to Form 990.18 Data on treatment intensity at the end of life
is provided by the Dartmouth Atlas of Health Care. We describe the Dartmouth Atlas data in more detail
in Section 6.

Apart from the IRS Form 990 data, we also use hospital financial statement information provided by
the Healthcare Cost Report Information System (HCRIS). HCRIS contains information from cost reports
submitted annually to the Center for Medicare and Medicaid Services (CMS) by all Medicarecertified
institutional providers, including hospitals. The reports contain detailed data on facility characteristics,
utilization, and cost, and it also include financial statement information, which we use in our tests.

The key variables for our analysis–i.e., capital expenditures and financial income measures–can be
constructed using either the IRS data or the HCRIS data. We use IRS data for our main analysis because
the IRS reporting of investments in securities is more reliable than reporting in HCRIS. In particular, some
hospitals choose to report their securities in HCRIS at historical cost rather than mark them to market,
and the database does not identify these cases. However, the HCRIS dataset has two advantages. First, it

16 The tax exempt organizations that are not required to file Form 990 are churches and state institutions.
17 We follow Guidestar in using the NTEE Classification System created by the National Center for Charitable Statistics.
Codes starting with an “E” refer to Health-related organizations and we focus on codes E21, E22 and E24 that together
make up the “Hospitals and Primary Medical Care Facilities” subgroup. Financial statements include most items typically
found on a (simplified) corporate balance sheet and income statement, although some accounts, in particular the equivalent
to book equity, are accounted for differently in the case of nonprofits as we point out in footnote 13 above. For a detailed
treatment of nonprofit accounting see Ruppel (2002).
18 Unrealized gains and losses from investments in securities are not reported in the financial statements filed with the IRS

for the period we analyze. The financial statements include only dividend and interest income and realized gains and losses.
However, investments in securities are recorded at market value on the Form 990 balance sheet, and unrealized gains and
losses must be included as part of Line 20 of Form 990 (“Other changes in net assets of fund balances”). The line
summarizes all changes in the organization’s equity (or fund balances in case of nonprofits) that do not flow through the
income statement. The breakdown of Line 20 into different types of adjustments is reported in the supporting statement
to Form 990, and we extract unrealized gains and losses manually from this attachment.

13
contains a breakdown of net fixed assets into land, buildings, and equipment, which allows us to examine
each investment category separately. Second, hospital identifiers in HCRIS correspond to those on
Dartmouth Atlas (the source of data on hospitals’ end-of-life treatment intensity), which ensures consistent
matching. For these reasons, we use the HCRIS dataset for a subset of tests that either require a breakdown
of investments into spending on land, buildings, and equipment, or require matching with Dartmouth
Atlas.19

4.2 Sample

Our main sample consists of 1,352 hospitals and 5,269 hospital-year observations from 1999 to 2006.
To construct the sample, we start with 3,555 hospitals. Each is characterized by distinct Employer
Identification Number EIN assigned by the IRS and has at least one million dollars in assets and at least
one million dollars in service revenue.20 Of the initial 3,555 hospitals, 1,521 report having some investments
in securities and also report valid information on investment income, the key variable for our tests (this
corresponds to 6,354 hospital-years). Investment income includes realized gains and losses, unrealized
gains and losses, and interest and dividends from securities, and we require that all three variables are
available for each hospital-year in our sample. Our final filter eliminates observations with extreme values
in our main variables: investment income divided by lagged net fixed assets, investment income divided by
lagged securities value, change in net fixed assets divided by lagged net fixed assets, operating income,
revenues and growth in revenues. These extreme observations seem to be caused by large changes in
hospital assets such as mergers or by hospital closures. To minimize the influence of such events, for our
main tests we exclude observations in the top or bottom one percent of the sample based on any of the
six variables. This last step eliminates 169 hospitals, resulting in 1,352 hospitals in the final sample.

The HCRIS dataset is constructed similarly to the Form 990 dataset. We start with 20,345 hospitalyear
observations for 2,324 nonprofit hospitals with the minimum of one million dollars in assets and one
million dollars in service revenues. When we limit the sample to observations with non-missing investment

19As an alternative, we matched the HCRIS and the Form 990 datasets using hospital names and repeated the tests on the
matched sample. Because coverage differs across the two databases, the matching procedure reduces the sample
considerably relative to the main analysis. After performing the match, we still find significant discrepancies in the values
of balance sheet statement of activities items reported on HCRIS and on Form 990 and impose additional data filters to
reduce incorrect matches. Based on conversations with experts on hospital accounting, the most likely reason for the
discrepancies is that hospitals sometimes include different entities in the consolidated reports provided to Medicare vs. the
IRS. The tests using the matched IRS-HCRIS sample are not reported, but they yield similar results as the main tests. 20
These requirements eliminate 1,958 organizations in the Guidestar database that appear to be either small hospitals, holding
companies for hospital systems with no significant service revenue, or miscoded observations.

14
income and financial variables, we are left with 10,457 observations and 2,061 hospitals. The final HCRIS
dataset, after eliminating extreme observations, consists of 1,895 hospitals and 8,847 observations.

4.3 Summary Statistics

Tables 1 shows summary statistics for the 5,269 observations (1,352 hospitals) in the IRS sample
included in the main regressions (see also Table A1 in the Internet Appendix for additional statistics and
splits of the sample). The left panel shows the full sample, and the right panel shows sub-samples split at
the median based on the size of net fixed assets or based the size of financial assets relative to net fixed
assets. The average hospital in the full sample has 189 million dollars in revenue (the median is 117 million
dollars) and 83 million dollars in net fixed assets, defined as net fixed assets minus accumulated depreciation
(the median is 48 million dollars). Financial investments constitute, on average, 82% of net fixed assets (the
median is 71%), which reflects the importance of financial assets for the hospitals in our sample. Net
income is on average 9% of lagged net fixed assets, while operating income–computed as program service
revenue minus program service expenses, excluding management and general expenses– is on average 36%
of lagged net fixed assets.20 For an average hospital, service revenue grows at an annual rate of 8%, which
matches the average growth rate reported by Moody’s (2011) for U.S. nonprofit hospitals during 1999-
2006. The average net debt to net fixed assets (calculated as bonds and other notes payable minus cash and
short term investments) is 49%, and about 64% of hospitals have tax-exempt bonds.

The first row of Table 1 shows that the mean of our main cash flow variable, income from investments
scaled by lagged net fixed assets, is 3% and the median is 2%. When investment income is scaled by the
lagged value of financial investments, the mean and median are 4% and 3%, respectively. For comparison,
the average value-weighted NYSE / AMEX / Nasdaq return is 6.5% during our 19992006 sample period.
The lower average returns for the hospitals in our sample are consistent with the nonprofits holding
significant fixed-income investments, which we confirm in conversations with several hospital executives
and financial advisors. The bottom lines of Table 1 show the breakdown of investment income into its
three components. Dividend and interest income make up about 40% of the total return, with realized and
unrealized gains and losses making up the remaining 17% and 42%, respectively. Our main outcome

20Program service revenue is revenue derived from activities that form the basis for the tax exemption. In case of hospitals,
these are primarily medical services.

15
variable–the change in net fixed assets scaled by lagged net fixed assets– has a mean of 4% and a median
of 2%.

Descriptive statistics for the HCRIS sample are in Table 2. The entities in HCRIS are, on average,
smaller than those in the IRS sample (e.g., the mean service revenue is $135 million compared to $178
million in Table 1) and have smaller financial assets in proportion to net fixed assets (mean of 0.50
compared to 0.82 in Table 1), consistent with the differences in reporting of financial assets discussed in
Section 4.1. Investment income in proportion to net fixed assets–the key variable for our tests–has the
same mean and median in both datasets. The average net income and the average growth rates for revenues
and net fixed assets are also similar across the two samples.

5 Returns from Securities and CAPEX

5.1 Empirical Specification

Our main regressions estimate the response of capital expenditures and other hospital expenses to
income from investments in securities. As explained in the previous section, investment income is the sum
of dividend and interest income and realized and unrealized gains and losses from securities. We run OLS
regressions of the following form:

, ,
, ,

.,
., ,
∆

, ,,
,

where ∆, is the change in the left-hand side variable used in each specification from t to
t+k. We consider one-year and two-year changes in net fixed assets and one-year changes in other lefthand
side variables. Flow variables are measured between t-1 and t and are scaled by net fixed assets to follow
the approach taken in the rest of the literature, including Fazzari et al. (1988, 2000), Kaplan and Zingales

16
(1997, 2000), Baker, Stein, and Wurgler (2003) and Rauh (2006). In addition to accounting for hospital size,
this has the advantage that the coefficient on cash flows can be interpreted as the dollar increase in assets
per dollar increase in cash flows. We also run an alternative specification in which investment income is
scaled by financial assets rather than net fixed assets.
We control for hospital size using the logarithm of total revenue and also for the size of hospital
investments in securities as a proportion of net fixed assets. We discuss these controls in more detail in the
next section. In the absence of a clean measure of marginal Q, especially for private companies, we include
growth in service revenue and operating income as a fraction of lagged net fixed assets to account for
changes in hospital investment opportunities. A perfect control for marginal Q is less critical as long as
returns on financial investments are uncorrelated with Q, which is an assumption we discuss in detail
below. We run regressions with and without hospital fixed effects, i, to account for the possibility of a
small-sample bias (Stambaugh (1999); see discussion in Lewellen and Lewellen (2012)). Year fixed effects,
t, are included in all regressions. Standard errors are heteroskedasticity robust and clustered at the hospital
and year level, to account for the possibility of correlation within both dimensions, as discussed in Petersen
(2009). In Table A2 of the Internet Appendix we show that our main results are robust to alternative
clustering procedures.

5.2 Identification

The key identifying assumption for all our tests is that returns obtained from securities portfolios are
uncorrelated with hospital investment opportunities. There are three ways this assumption could be
violated. First, aggregate stock market returns could be correlated with investment opportunities in the
hospital sector. To address this, we include year dummies in each regression, so that the tests rely only on
the within-year cross-sectional variation in hospital returns. A related concern is that a hospital’s investment
opportunities could be linked to the local rather than market-wide economic conditions. If hospital
investment portfolios are tilted towards local firms, the idiosyncratic component of a hospital return could
be associated with local demand for healthcare, and thus hospital investment opportunities. The point
estimate of our coefficient of interest is virtually unchanged when we include state-year fixed effects, so
that regional economic conditions do not seem to be an important driver of the results.

Second, hospitals may differ with respect to the stock picking skills of their investment managers or
investment advisors. If hospitals with higher skills (and thus higher average returns) are also better at
managing capital investments, they may exhibit higher capital spending on average. In this spirit, Lerner,

17
Schoar and Wang (2008) show that university endowment returns are correlated with the quality of the
student body and the prestige of the institution. We control for hospital specific skill using hospital fixed
effects, so any remaining skill effect would have to come from time varying hospital quality. Based on
Lerner, Schoar, and Wang (2008) this is not a significant concern. They argue that skill comes mostly from
the top institutions’ ability to gain access to unique financial investments, and such ability is likely to persist
over time. Also, in general, finance literature finds little evidence of stock picking skill among mutual fund
managers (see, for example, Fama and French (2010)), suggesting that skill is unlikely to drive realized
returns in our sample.

Another concern might be that hospitals tailor their portfolios so that portfolio returns are high at
times when investment opportunities in the healthcare sector are also high, and when hospitals need funds
to invest. To achieve such correlation, hospitals might choose to tilt their portfolio towards investments in
the healthcare sector. There are a couple of reasons why this is unlikely to drive our results. First, this
strategy would magnify the variability of a hospital’s overall income, and thus would likely not be desirable
to managers. In fact, the notion that investments would be tailored to be high during times of high
investment opportunities was consistently dismissed by the hospital executives we talked to. Second, and
given that our sample includes hospitals only, the inclusion of year fixed effects should absorb most of the
variation coming from industry-wide shocks.

A related issue is that hospitals might adjust their asset allocation either towards riskier or towards safer
investments at times when they anticipate large capital investments. This would create a correlation
between hospital expected returns and future investment. However, our regressions use realized returns–a
noisy measure of expected returns–making it highly unlikely that time-varying expected returns could
explain our results. We confirm this intuition using a simulation described in the Internet Appendix, Table
A13. As an additional robustness test, we decompose each hospital’s realized returns into their expected
and unexpected components following the decomposition in Rauh (2006).21 Consistent with that paper,
we find that the coefficient on the unexpected component is similar to the coefficient on the realized return
(this test is also included in the Internet Appendix, Table A12).

21 Like Rauh (2006), we assume that each hospital allocates its financial assets into a diversified stock index and a
government bond. The weights each year are calculated from the realized return on the hospital’s portfolio and the actual
stock market index and bond returns during the same year. Using the imputed portfolio weights and expected returns for
each asset class, we compute expected returns for each hospital in each year. The unexpected return is the difference
between the realized and the expected return.

18
5.3 Sensitivity of CAPEX to Returns on Securities

Table 3 shows our main results. We find that one additional dollar of investment income leads to an
increase of 10 cents in net fixed assets in the subsequent year, and this estimate is not affected by the
inclusion of hospital fixed effects. This means that a one standard deviation change in investment income
scaled by lagged net fixed assets (which is six percentage points) translates into a 0.6 percentage point
change in asset growth (the average growth is four percentage points). In the last two columns of the left
panel, we scale investment income by the lagged holdings of securities rather than lagged net fixed assets.
This variable measures the actual return on financial investments, and it is also positively and significantly
associated with future capital spending. A one standard deviation change in investment return translates
into a 9.4 percent change in the asset growth rate (or 0.41 percentage points).

In the right panel of Table 3, we consider longer-run effects of the cash flow shocks from securities
on capital investments. The goal is to account for the fact that investments may take time to implement.
Specifically, we examine asset growth over two years following the investment return. We find that the
coefficients on investment income are larger and statistically more significant than in the one-year analysis.
Based on the first column, one additional dollar of investment income is associated with a 23 cents increase
in net fixed assets over the two subsequent years. This means that a one standard deviation change in
investment income scaled by lagged net fixed assets translates into a 1.3 percentage point increase in the
two-year growth rate of net fixed assets. The results are similar when we scale investment income with
lagged holdings of securities instead of lagged net fixed assets. We repeat these tests using HCRIS data in
Table A3 of the Internet Appendix and find similar results.

5.3.1 Interpreting the magnitudes

The tests in Table 3 reject the frictionless benchmark model of a nonprofit firm in Section 2.2.1 that
predicts investment-cash flow sensitivities close to zero. An alternative benchmark is the investmentcash
flow sensitivity implied by the nonprofits’ internal spending rules. The rules are typically set by the
organizations’ boards of trustees, and they determine the amount of funds the organization is allowed to
appropriate for expenditure from its endowment each year. The rules offer an interesting reference point
because they can be interpreted as an indication of what trustees (and thus donors and taxpayers) typically
consider to be the appropriate level of spending as a function of the endowment’s performance. Taking
this perspective, we ask how the nonprofits’ actual spending patterns compare to those implicit in their
spending rules.

19
 Although we do not have systematic evidence on spending rules for hospitals, the
NACUBOCommonfound Study of Endowments reports such evidence for a large sample of U.S.
universities and colleges. According to conversations with industry specialists, the most common rules
described in the study appear to be also used by hospitals. According to the 2010 NACUBO study, 75%
of surveyed organizations define the amount of funds available for appropriation each year as a fraction
(typically 34%) of the three-year moving average of the endowment’s market value. For example, a strictly
applied four-percent rule implies that a dollar increase in the value of the endowment in year t-1 would
increase spending by one-third of four cents, i.e., by 1.33 cents, in year t (this is because the endowment
value in year t-1 has a weight of one-third in the moving average). In contrast, the regressions in Table 3
show that actual spending on net fixed assets in year t increases by approximately 10 cents for each
additional dollar of financial income in year t-1, implying a substantially higher sensitivity. Thus hospitals
appear to increase investment more strongly in response to cash flow shocks than the typical rules imply.

In practice, a hospital’s investment could deviate in a number of ways from the amount obtained by a
direct application of the spending rule (i.e., in the example the amount equal to 4% of the moving average
of the past endowment values). First, the spending rule determines the amount of funds that can be taken
out of the endowment in a given year, but the actual spending in that year could be higher or lower than
that amount. For example, an organization could finance its expenditures from funds available outside of
the endowment, or it could choose to save the appropriated funds for future expenditures. Second, the
rule defines the amount of endowment funds available for total spending rather than for spending on net
fixed assets alone. Thus in the example, a strict application of the rule to total spending suggests that
investment-cash flow sensitivity may be below the 1.33 estimate (if some of the 1.33 cents is used for non-
CAPEX spending). Finally, spending rules can be changed or overruled by nonprofits’ boards of trustees,
which gives the organization additional flexibility to adjust its spending rate. For example, Sedlacek and
Jarvis (2010) report that in 2009, 18% of organizations surveyed by NACUBO used special appropriations
of endowments funds, that is, appropriations in excess of those permitted by the spending rule.22

As a final comparison, it is informative to relate the investment-cash flow sensitivities in Table 3 to

those of for-profit firms. We do not directly compare the sensitivity of for-profit and nonprofit hospitals
because for-profit hospitals do not have endowments, and identifying hospital responses to cash flow
shocks using operating cash flows would be problematic because of the confounding effects of Q (this is
especially true in our setting because standard controls for Q are not available for private firms). However,

22Based on evidence in Sedlacek and Jarvis (2010), the special appropriations appear countercyclical: the percentage of
organizations reporting special appropriations is close to 15% from 2005 to 2007 but it increases to 19% in the crisis year
of 2008 and remains high at 18% in 2009.

20
based on large-sample studies of for-profit firms, our estimate of 10 cents per dollar of income does not
appear high. For example, Cleary (1999) and Baker, Stein, and Wurgler (2003) report values of $0.05–0.15
for for-profits. Using alternative methods to correct for measurement error in Q, Gilchrist and
Himmelberg (1995) estimate adjusted investment-cash flow sensitivities of $0.17, Ericson and Whited
(2001) of zero, and Lewellen and Lewellen (2012) of $0.18. Rauh (2006) reports an estimate of $0.11 but
also shows that firms cut investment by $0.60-0.70 in response to a dollar of mandatory pension
contributions. Thus based on these studies, the responsiveness of investment to cash flow shocks is similar
for for-profit and nonprofit firms. To the extent that the literature is successful at identifying the effects
of frictions, this comparison suggests that the impact of frictions on investment does not differ
substantially across the two organizational forms. 23

5.3.2 What types of spending respond to cash flow shocks?

Table 4 shows how the changes in net fixed assets are allocated among their different components.
The tests are based on the HCRIS data described in Section 4.1 for which we have a breakdown of net
fixed assets into different categories. 24 The regressions are similar to those in Table 3, except that
investment is measured separately for three types of net fixed assets: land, buildings and equipment. The
equipment variable includes five sub-categories (Graning (1967): fixed equipment (built in items such as
cabinets, counters or elevators); Cars and Trucks; Major Movable Equipment (large equipment items that
can be moved but are typically stationary, such as X-ray or MRI machines); and two categories for minor
equipment (like surgical instruments or sheets and linen) broken down by whether it can be depreciated or
not.

Some authors suggest that medical equipment might be particularly prone to overspending because it
involves relatively small ticket items with potentially large private benefits for doctors (e.g., Glaeser (2003)).
If overspending drives investment-cash flow sensitivity in our sample (and if spending on equipment is
indeed more “insider-driven” than spending on buildings), we may observe especially high sensitivity for
this category of expenditures. The regressions in Table 4 do not support this joint hypothesis, as we cannot
distinguish statistically the sensitivity of spending on equipment and that on buildings. For example, in
regressions without hospital fixed effects, the coefficients on investment income are 0.05 for equipment

23 Most estimates in the literature use investment measured over one year and are thus more comparable with the $0.10
estimate in this paper (rather than the $0.23 estimate investment measured over two years).
24 As discussed earlier, HCRIS contains a less reliable measure of investment income compared to the IRS dataset. In spite

of this drawback, the basic investment-cash flow sensitivity regressions conducted using the HCRIS data yield results
consistent with those reported in Table 3 (see Table A3 in the Supplementary Appendix).

21
and 0.06 for buildings, with t-statistics of 2.01 and 1.17, respectively. Including hospital fixed effects
weakens the results on equipment spending. There is no evidence that investment income is associated
with spending on land.

Table 5 tests whether investment income affects other categories of spending reported on the IRS
form. We consider four different types of expenses: salaries of officers and directors, other salaries paid,
conference expenses, and travel expenses. We observe only total executive and other salaries, so we cannot
distinguish the effects of cash flow shocks on the number of employees vs. on salaries per employee. The
dependent variable in each regression is the growth rates in expenses during the year following the
measurement of cash flows. As a robustness test, we also use as the dependent variable the change in each
expense item scaled by the lagged net fixed assets and obtain similar results.

In the executive compensation regressions, the coefficients on investment income are both positive
but statistically insignificant, with t-statistics of 1.02 and 0.77. A one standard deviation shift in the return
variable translates into a one percentage point change in the growth rate of executive compensation (the
mean growth rate is 14.5 percent and the median is 8 percent). For all other compensation, this estimate is
0.1 percentage point and it is also statistically insignificant (the mean and median growth rates are close to
7 percent). The coefficients on conference or travel expenses are negative in three out of the four
regressions, with t-statistics from -0.89 to 0.95.

Overall, the regressions suggest that salaries and perks do not respond significantly to cash flow
shocks, although we cannot rule out that the tests lack power to detect significant effects. There are two
potential explanations for these findings. First, though salary and perks directly benefit insiders, the
expenditures might be relatively easy for boards to monitor, so that excessive spending is not a significant
concern. Glaeser and Shleifer (2001) make a similar argument and suggest that private benefits in
nonprofits might take a less tangible form than direct pay. Interestingly, however, Bertrand and
Mullainathan (2001) find that CEOs of for-profit firms appear to be “paid for luck”, suggesting
excessive executive pay even in the presence of shareholders. In the context of hospitals, Brickley,
Van Horn, and Wedig (2010) find evidence of excessive CEO pay in a sample of hospitals with weak
boards.25

25Specifically, they find that boards with insiders as members pay higher CEO salaries. They also show that in hospitals
with insider boards, executive salaries respond positively to operating profits.

22
 An alternative interpretation is that hospital salaries (and perks) are influenced by insiders, but that
insider influence does not make spending significantly more sensitive to cash flows. The traditional
argument in favor of higher sensitivity is based on the assumption that skimming is easier for insiders to
implement when internal cash flow is high, in part because it is easier to conceal. However, this assumption
is difficult to verify directly. More generally, it is possible that some expenditures are persistently too high,
or that excessive spending is independent of financial performance. We explore this possibility further in
Section 6.

5.3.3 Financing constraints

Another potential explanation for investment-cash flow sensitivities in the literature is the presence
of financing constraints, and this is the explanation we focus on in this section. Specifically, we test whether
financing constraints contribute to the sensitivity of investment to cash flows documented in Table 3. To
do so, we compare investment-cash flow sensitivity for sub-samples formed based on exante measures of
constraints. We use three measures of financial slack: the level of net debt, the level of financial
investments, and the level of net debt minus financial investments. Each variable is measured one year
before the measurement of cash flows, and it is scaled by the contemporaneous net fixed assets. In Table
6 we pool the entire sample and test whether investment-cash flow sensitivities differ across the different
hospital groups. We also report a specification that includes hospital fixed effects in Table A4 of the
Internet Appendix, as well as separate investment regressions for the different samples split by financing
constraints in Table A5 in the Internet Appendix.

Overall, the tables show that investment-cash flow sensitivities increase significantly with the level of
ex-ante constraints. For example, based on Table 6, firms in the top tercile formed based on the level of
net debt exhibit significantly higher sensitivity of capital spending to investment income than firms in the
bottom tercile. The difference corresponds to 26 cents on each dollar of investment income, and the
corresponding t-statistic is 2.99. When we split the sample at the terciles based on the level of financial
investments rather than net debt, we obtain a difference in sensitivity between the top and the bottom
tercile corresponding to -16 cents with a t-statistic of -1.27. Finally, using a split based on net debt minus
financial investments yields a differential effect of 27 cents with a t-statistic of 1.90. Conclusions are similar
when we split the variables at the median, instead of using terciles. Overall, the analysis in Table 6 (and
Tables A4 and A5 of the Internet Appendix) suggests that financing constraints are an important driver of
the investment-cash flow sensitivities documented in Table 3.

23
6 Treatment intensity and overinvestment

This section re-examines the link between investment-cash flow sensitivity and agency problems, and
specifically overspending on medical procedures by insiders, using a new hospital-specific data source.
There are few direct tests of overspending (or overinvestment) in the corporate finance literature because
excessive spending is difficult for researchers to identify.26 Hospitals offer a unique setting to explore these
issues. This is because a large literature in healthcare economics focuses on identifying and measuring
excessive spending by hospitals (relative to patient need), and insights from this research can be used to
test whether overspending and cash flow-investment sensitivity are related.

The key to these tests is the idea that spending resources on medical procedures that bring no benefit
to patients is inefficient from the perspective of the hospital’s residual claimants, in particular, the
community or donors, and is contrary to hospitals’ stated mission. An important assumption is that well
governed nonprofits will avoid “over-treating” patients, even if this is privately optimal for insiders. We
test whether hospitals that score high on measures of overtreatment are also those that increase
expenditures when cashflows are high. We start with a brief overview of the relevant literature (an extensive
survey can be found in Skinner (2012)).

6.1 Variation in treatment intensity: background

Research on the nature and efficiency of medical spending spans many decades with the oldest studies
dating back to the 1930s. One of its key insights is that medical spending varies strongly across geographic
regions, and that much of the variation cannot be explained by observable factors such patient population,
income level, market structure, and other patient and hospital characteristics. 27 Numerous studies
document this pattern for a wide variety of diagnoses, time periods, and geographic areas. As an example,
Wennberg and Birkmeyer (1999) document large unexplained variation in the use of beta blockers for
200,000 heart attack patients across the U.S. in 1994-1995. The variation is especially puzzling given that
nearly all patients in their sample should have received the treatment.28 Similar patterns have been reported,
for example, for tonsillectomy (Glover (1938), Wennberg and Gittelsohn (1973), Suleman et al. (2010)),

26 Yermack (2006) and Edgerton (2012) use corporate jets as a prominent example of expenditures that are likely to be
driven by agency problems.
27 E.g., Sutherland et al. (2009), Gottlieb et al. (2010), and Zuckerman et al. (2010)
28 The actual treatment rates varied substantially across regions (e.g., it was 5% in McAllen, Texas and 90% in Albany,

Georgia). This is despite the fact that the effectiveness of beta blockers had been well documented at the time, and that
the treatment was relatively inexpensive.

24
Cesarean section (Gruber and Owings (1996), Epstein and Nicholson (2009)), PSA testing, including for
men over 80 (Bynum et al. (2010)), and other types of medical interventions.

The literature attempts to identify reasons for the unexplained variation in treatment intensity, and a
prominent view is that the variation is driven, to a large extent, by regional and hospital-specific norms and
doctor preferences, or are caused by differences in excess capacity. Norms and preferences are especially
important in cases when benefits of treatment to patients are small or not well understood (socalled
Category III treatments, Skinner (2012)): absent clear clinical evidence in favor of one treatment vs. another
(or no treatment at all), doctors are more likely to rely on personal views, prevailing norms or rules of
thumb.

A prominent example of Category III treatments in the literature–and one that we focus on in this
paper–are certain treatments administered to terminally ill patients at the end of their lives. These
treatments are classified as Category III because there is no clear-cut clinical evidence that more treatment–
at levels typical in the U.S.–is better for patients, either in terms of prolonging life or improving quality of
life. Still, there is substantial variation in the use of these treatments across hospitals, including the very
best ones, and there is no clear consensus on what treatment levels are optimal for patients (Wennberg et
al. (2004)). Moreover, research on patient choices at the end of life suggests that patient preferences are
unlikely to explain this cross-sectional variation, and that preferences are often trumped by hospital-specific
practices.29

6.2 Hypotheses

In this section, we consider differences in cash flow investment sensitivity of hospitals with different
levels of per-patient spending (or treatment intensity) at the end of life. To interpret the tests, we assume
that high-intensity hospitals spend too much per patient, relatively to what is optimal from the perspective
of taxpayers, donors, or the society at large. This assumption could be reasonably debated, and there is no
perfect way to identify ‘unwarranted’ vs. ‘justified’ medical spending (see, for example, Doyle, Graves,
Gruber and Kleiner (2012), Doyle (2011), and Stukel, Fisher, Alter, et al. (2012) for settings in which higher-

29For example, a study of dying Medicare patients during the period of 1992-1993 asks patients where they prefer to die,
in the hospital or at home, and then studies the determinants of the actual place of death. It finds considerable regional
variation in the propensity to die in the hospital. Patient preferences, socioeconomic factors or clinical factors have no
explanatory power in explaining this variation, and the strongest determinant is the availability of hospital beds in the
region (Pritchard , Fisher, Teno et al. (1998)). See also Anthony, Herndon, Gallagher et al. (2009) and Barnato, Herndon,
Anthony, et al. (2007).

25
cost interventions are associated with better outcomes for patients)30. However, three arguments speak in
favor of our approach. First, given the frictions in the market for hospital services, it is reasonable to
assume that individual hospitals systematically over- or under-supply treatment. 31 Second, we identify
overspending by focusing on Category III treatments for which the benefits to patients are clinically least
well established, and where idiosyncratic factors are most likely to drive supply. Third, the measures
themselves account for differences in race, gender and primary chronic condition, which soaks up most of
the variation in terms of “need” for treatment. Finally, our tests control for observable hospital
characteristics–including size, case mix (i.e., the average complexity of a case), or hospital type– and thus
focus on hospital specific unexplained variation in intensity.

Our goal is to establish empirically whether a hospital’s tendency to “overspend”–as measured by the
end-of-life (EOL) treatment intensity–is associated with higher investment-cash flow sensitivity. The
assumption is that better governed hospitals (where insiders’ incentives are better aligned with those of the
residual claimants) avoid spending resources on procedures that do not benefit patients. This would be the
case even if such procedures generate revenue to the hospital or benefit insiders directly, for example
through increased patient volume, prestige, or perks. Finding that hospitals that score high on measures of
overtreatment are also those that respond more strongly to cash flow shocks would be consistent with
agency-conflicts explanations for investment-cash flow sensitivities.

6.3 Data and descriptive evidence

Data on the use of end-of-life (EOL) treatments by hospital comes from The Dartmouth Atlas of
Health Care based at The Dartmouth Institute for Health Policy and Clinical Practice. The database
contains information from the Center for Medicare and Medicaid Services (CMS) research files, which
include detailed data on Medicare claims and beneficiaries. We rely on the sample constructed by the
Dartmouth Atlas and used commonly in studies on EOL treatment. The original population includes
4,732,448 Medicare beneficiaries who (1) died over the five-year period from 2003 to 2007; (2) were

30 For example, Stukel, Fisher, Alter, et al. (2012) show that hospitals in Ontario, Canada that ranked higher on end-of
life treatment intensity measures exhibited lower mortality, readmission, and major cardiac events rates for their
populations of patients with a first admission for acute myocardial infarction, congestive heart failure, hip fracture, or
colon cancer (see also a discussion of this study in (Joynt and Jha, 2012)).
31 Most importantly, consumers do not pay for services directly, and providers face a range of conflicting incentives,

including loyalty to patients, monetary incentives, and malpractice risks.

26
hospitalized in an acute care hospital at least once during the last two years of life; (3) had at least one of
nine chronic illnesses associated with a high probability of death32; (4) were 67 to 99 at the time of death.

The patients are assigned to the hospitals they used most frequently in the last two years of life (except
for the capacity utilization measures described below, for which patients are grouped by place of residence).
For each measure, we only have the hospital-level average over the time period. To minimize noise,
Dartmouth Atlas includes only hospitals with a minimum of 80 deaths in the sample. An important feature
of the EOL measures in Dartmouth Atlas is that they are backward-looking, that is, they condition on
patients’ death and thus exclude severely ill patients that survive, possibly as a result of treatment. Skinner,
Stager, and Fisher (2010) report the Atlas measures are highly correlated with similar forward-looking
variables, with correlations close to 90%.33

Table 7 shows descriptive statistics for the EOL measures by hospital and for other hospital-level
characteristics, and Table A6 of the Internet Appendix shows the corresponding correlation matrix. All
measures are adjusted for age, sex, race, primary chronic condition, and whether patients had more than
one of the nine chronic conditions. The first two variables measure the percentage of patients that during
their last six months of life (1) saw more than 10 different physicians and (2) received care in an intensive
care unit. The first measure is available for 1,193 hospitals in our sample, and the second measure is
available for 1,358 hospitals. In addition, we also use the percentage of cancer patients that received life
sustaining interventions during the last one month of life. This measure is available for a subset of 293
hospitals in our sample. In addition to the EOL measures, the table shows descriptive statistics for a
number of hospital characteristics included in the Atlas database, such as the hospital case mix index,
Medicare quality score, and dummy variables for teaching hospitals and National Cancer Institute (NCI)
cancer centers.34 It also includes two capacity variables measuring the number of beds and the number of
specialist per 1,000 residents in the hospital’s Hospital Service Area (HSA; a geographic unit constructed

32 The primary chronic conditions are Malignant Cancer/Leukemia, Congestive Heart Failure, Chronic Pulmonary Disease,
Dementia, Diabetes with End Organ Damage, Peripheral Vascular Disease, Chronic Renal Failure, Severe Chronic Liver
Disease and Coronary Artery Disease.
33 In this paper, we use the Atlas measures to identify high-intensity hospitals (i.e., hospitals with high per-patient spending).

The fact that the measures are constructed using a sample of patients who die does not seem problematic for our tests. As
a robustness test, we use a sample for which the selection of dying patients is least likely to be significant (cancer patients
during their last few weeks of life) and obtain qualitatively similar results as in the main tests.
34 Case Mix Index (CMI) is a summary measure of the clinical complexity of Medicare cases treated in a hospital. Higher

CMI indicates more complex cases. The Medicare quality scores are provided by the Hospital Quality Alliance (HQA) and
are available on the CMS Hospital Compare website. The measures attempt to capture the extent to which a hospital
provides timely and effective treatment for a number of specific medical conditions. The overall quality score we use in
this paper summarizes measures for treating acute myocardial infarction, congestive heart failure, and pneumonia. The
National Cancer Institute (NCI) is a dummy for hospitals that are NCI-designated Cancer Centers engaged in active cancer
research.

27
by Dartmouth Atlas using Medicare discharge data meant to capture local health care markets for hospital
care).

Table 8 shows descriptive regressions of the EOL measures on various hospital characteristics. The
patterns in Table 8 are broadly consistent with prior literature. First, there is no clear relation between the
EOL measures and various proxies for hospital quality: the coefficients on the teaching hospital dummy
and case mix index switch signs depending on the specific EOL measure and are often not statistically
significant (although there is some evidence that in hospitals with more complicated cases, patients see
fewer doctors). The coefficient on the Medicare quality score is negative for two out of the three measures.
Capacity is generally positively associated with the intensity of treatment. For example, the coefficient on
the number of specialists per 1,000 residents in the hospital’s HSA is positive and significant for all
measures. Similarly, the coefficient on the number of beds measure is positive for the two measures directly
linked to hospitalization and significant for one of the measures. Larger hospitals (where we measure size
by the logarithm of total revenues) tend to provide more intensive treatment in the broader patient
population, but less intensive treatment in the population of cancer patients. There is also some evidence
that more intensive hospitals have higher debt and smaller financial assets. Table A7 in the Internet
Appendix shows the economic magnitudes of all coefficients.

6.4 Main results

The investment regressions involving EOL treatment measures are in Table 9. The regressions in Panel
A of Table 9 are similar to the main tests in Table 3, except that they include interaction terms of investment
income with the intensity measures (as well as the intensity measures directly). In addition to the individual
EOL measures, the tests use a summary measure, the EOL Index. To construct the index, the hospitals are
sorted into terciles based on each of the two intensity measures available for the large sample (Percent Patients
Seeing > 10 Physicians (6m) and Percent Medical and Surgical Interventions (6m)). This sorting is done within the
sub-sample of hospitals for which all control variables used in Table 8 are nonmissing. The index
corresponds to the sum of the tercile ranks and takes on values between 2 and 6. The regressions include
the same controls as Table 3, and also a specification with all the hospital-level variables used in Table 8.

Based on Panel A of Table 9, investments of higher-intensity hospitals are less sensitive to cash flows.
The coefficient on the interaction term of investment income with intensity is negative in all eight
regressions and is statistically significant in seven out of the eight regressions. Focusing on the EOL index
regressions in column 5, a one-standard deviation increase in the index lowers cash flow investment
sensitivity by 21 cents per dollar of income (the t-statistic is -2.31). The last two regressions use the

28
percentage of cancer patients receiving life sustaining treatment within the last month of life as a measure
of treatment intensity. These regressions provide a useful robustness test because they focus on an
especially homogenous group of patients. The table shows that, in spite of the significantly smaller sample
for which the measure is available, the results are consistent with the full-sample tests. We find similar
results when we include hospital fixed effects (Table A8 of the Internet Appendix).

Overall, the tests provide no evidence that high-intensity hospitals exhibit higher sensitivities of
investment to cash flows. In fact, the results suggest the opposite: capital expenditure of higher-intensity
hospitals appears less dependent on financial performance. Interpreting intensity as a measure of
overspending, these results seem at odds with the idea that organizations with a stronger tendency to
overspend are also those that spend more when cashflow is high.
A possible explanation for the negative interaction effects in Panel A is that hospitals that supply
unusually low levels of treatment intensity might be financially constrained, and that the hospital-level
controls in Table 9 do not fully account for the effect of constraints.35 (Table A9 in the Internet Appendix
repeats the tests allowing for non-linear effects of debt with similar results.) The tests in Panel B of Table
9 explore this possibility in more detail. In this panel, hospitals are sorted into three groups based on the
EOL index, and the high-intensity (T3) hospitals are compared to the median (T2) group. The median
group is a useful benchmark because it excludes hospitals with the lowest intensity levels (T1) within which
financing constraints might be most frequently binding.

Consistent with the results in Panel A, the regressions in Panel B show no evidence that the
highestintensity hospitals in the T3 group exhibit higher investment-cash flow sensitivities than the
benchmark sample. In the first two columns of Panel B, the coefficients on the interaction term between
investment income and T3 (the T2 indicator is left out) are negative and statistically insignificant (the t-
statistics are 0.42 and -0.29). Interestingly, the lowest-intensity hospitals (T1) show higher sensitivities than
the benchmark group, consistent with the presence of financing constraints: the interaction of investment
income with T1 is positive and statistically significant (the t-statistics are 1.74 and 2.07). Based on the
regression with all controls included, moving from the middle to the low intensity group increases the
investment-cash flow sensitivity by 30 cents.

The regressions in the last three columns of Panel B provide additional evidence that the high
sensitivities in the T1 group are associated with financing constraints. When we split T1 hospitals into sub-

35 If low-intensity hospitals undersupply treatment, they might have higher demand for financial resources as they
attempt to increase output. As a result, their capital expenditures could be more sensitive to cashflow shocks even after
controlling for debt.

29
samples based on the ratio of net debt to net fixed assets, we find sensitivities of 55 cents in the above-
median debt group compared to 15 cents for the below-median debt group, and the t-static for the
difference is 1.89. A similar comparison within the benchmark T2 group yields sensitivities of 3 cents and
-6 cents for the above- and the below-median debt sub-samples, with the t-static for the difference of 0.58.
These results are consistent with financing constraints causing the high investment-cash flow sensitivities
within the low-intensity group.

In sum, the evidence in Tables 8 and 9 combined with the prior research on end-of-life treatment, casts
some doubt on the idea that agency problems associated with overspending are a key driver of hospitals’
investment-cash flow sensitivities. One interpretation of these tests is that high-intensity hospitals spend
more on treatment than is desired by their communities and donors. Taking this perspective, our tests
provide no evidence that this type of agency conflicts translate into higher sensitivities of investment to
cash flows. Instead, we find that high sensitivities are concentrated among hospitals supplying unusually
low levels of end-of-life treatment, compared to the national average, especially if such hospitals have higher
levels of debt. Overall, these results are consistent with the evidence in Section 5 that also points to
financing constraints as the key explanation for why hospitals increase investment when their cashflows
are unexpectedly high.

7 State Oversight and Hospital Investments

Our final set of tests explores the impact of regulation on hospital investment. A number of U.S. states
regulate hospital investments as part of the so-called Certificate of Need (CON) laws. The laws require
hospitals to obtain approval from state authorities for expansions of infrastructure (new buildings or
improvements to existing buildings) and, in some states, also for significant investments in equipment. The
laws were put in place mostly during the late 1960s and 1970s with the purpose of containing healthcare
costs and aligning hospital spending with regional “needs”. The federal law requiring states to have CON
regulation expired in 1986, and since then fourteen states dropped the laws, mostly during the second half
of the 1980s.36

The effects of CON laws have been analyzed extensively in the literature (an overview is in Conover
and Sloan (1989)). Researchers have examined, among other things, the effects on hospital costs, capital
expenditures, bed supply, and diffusion of specific technologies. The majority of the studies surveyed in

36The list of states is in Appendix B. A frequently cited reason for the decline in the popularity of CON laws is that the
introduction of the Medicare’s Prospective Payment System and the growth in managed care provided alternative and,
arguably, more effective mechanisms to contain healthcare costs.

30
Conover and Sloan (1998) find no significant effect of CONs on these outcomes, and some studies report
contradictory findings. There is some evidence that, as a result of CON laws, hospitals substitute less
regulated categories of spending for more regulated ones (Salkever and Bice (1976, 1979), Sloan and
Steiwald (1980)). In spite of the lack of conclusive evidence that CON regulation is effective, the laws
remain in place in the majority of states.

This paper investigates how hospital investment responds to shocks to financial income, and given the
prevalence of CON regulation, it seems natural to ask how this response varies across states that regulate
hospital investments vs. states that do not. Specifically, we ask whether investment responds more or less
strongly to cash flow shocks in states that directly oversee investment spending.

Conceptually, the answer to this question depends on the specific rules states use to evaluate and reject
projects, and on hospitals’ response to these rules (we discuss this in more detail below).

To answer this question empirically, we repeat the cash flow-investment sensitivity regressions in Table
3, including an indicator variable for hospitals located in CON states and an interaction of the CON
dummy with investment income. We measure capital expenditures over one- and two-year horizons to
account for the fact that the CON approval process may delay investment, and we show regressions with
and without hospital fixed effects. The results are reported in Table 10.

The table shows that the interaction effect is negative in all regressions, implying that investmentcash
flow sensitivity is lower in regulated states. When investment is measured over one year, the coefficients
on the interaction term are -0.14 and -0.10 in regressions without and with hospital effects, respectively (t-
statistics are -1.93 and -1.09). For example, based on the regression with hospital fixed effects, the
coefficients imply that investment-cash flow sensitivity is 0.17 for the 14 states without CON laws, and it
is 0.07 for the 39 states with CON laws. The effects are larger when investment is measured over two years.
As a robustness test, we repeat the analysis after controlling for a number of state characteristics, including
measures of healthcare spending per capita, population age, Medicare spending, HMO penetration,
hospital concentration, and share of for-profit hospitals and find similar results (the tests are in Table A11
and the descriptive statistics are in Table A10 of the Internet Appendix).

The large differences in investment-cash flow sensitivities across states with and without CON laws
could be caused by differences in state characteristics that we do not fully control for. It is also possible
that the states’ decisions to repeal the laws were in some way dependent on the way in which local hospitals

31
invest. Another plausible interpretation is that the findings reflect, at least in part, a causal effect of CON
laws on investment. We discuss this possibility below.

The evidence from prior studies suggests that the laws have no significant impact on the level of
investments, so finding a significantly negative effect on the slope (i.e., on the sensitivity of investments to
cash flows) raises the possibility that the laws constrain investment more strongly when cash flow is high.
Such pattern would be consistent, for example, with a simple rule whereby CON agencies reject projects
more often when investment–if unregulated–would be unusually high. For financially constrained hospitals
this would be the case precisely when financial performance is good, so that projects can be financed from
internal sources. The result is also consistent with a somewhat more sophisticated state agency, i.e., one
that tends to reject (or deter) projects more often when they appear less valuable, assuming that, for
financially constrained hospitals, such instances are more likely to occur when cash flow shocks are high.
In either case, hospitals anticipating the state’s behavior might themselves smooth investment across time
and thus minimize the law’s impact on the overall investment levels (consistent with substitution across
categories of spending documented earlier in (Salkever and Bice (1976, 1979), Sloan and Steiwald (1980)).

Though our tests cannot identify the precise mechanism generating the lower slope in CON states, the
results suggest that CON agencies might have a measurable effect on investment in some states of the
world (consistent with an insignificant effect on average found in prior studies). Indirectly, the results are
also consistent with hospitals facing financing constraints, and CON agencies having a bigger impact when
these constraints are relaxed.

8 Conclusions

This paper examines investment decisions of nonprofit hospitals. Nonprofit firms do not have owners
in the usual sense, and their governance systems differ fundamentally from those of corporations. Prior
studies have argued that nonprofit insiders have more power over the resources of their organizations than
managers of for-profit firms do and that, if unchecked, this power would lead to self-serving behavior,
including excessive spending and overinvestment. Investment of nonprofit firms might exhibit additional
distortions because of the firms’ inability to obtain equity financing. In this paper, we examine the potential
effects of agency problems and financing constraints on hospital investments. Our empirical approach is
based on Q theory and its key prediction that, in the absence of frictions and controlling for Q, a firm’s
investment should be unresponsive to cash flows.

32
 The hospital setting allows us to test this implication in a novel way, thus sidestepping some of the
empirical challenges faced by prior literature. The key challenge has been to identify cash flow shocks that
are unrelated to Q. Nonprofit hospitals are interesting in this context because, in contrast to corporations,
they typically hold large financial assets and shocks to the performance to these assets can be used as a
source of exogenous variation in cash flows. Using this approach, we find that hospital investment
increases, on average, by 10-28 cents for every dollar received from investments in securities, thus implying
the presence of frictions. The estimates are similar in magnitude to those found earlier for shareholder
owned corporations. This is interesting because for-profit firms are arguably better governed than
nonprofits and because they have access to equity financing, which should alleviate financing constraints.

We then consider the potential mechanisms responsible for the investment-cash flow sensitivities we
observe. The precise nature of the frictions that cause investment to respond to cash flows is not well
understood (Stein (2003)), and we use the unique data on hospital spending to shed light on this question.
We find that investment-cash flow sensitivities are substantially higher for hospitals that appear to be
financially constrained–based on their levels of debt or financial assets–and that the sensitivities are close
to zero for unconstrained hospitals. We find no conclusive evidence that agency problems are associated
with investment being more responsive to cash flow shocks. For example, we do not find that salaries or
perks respond significantly to cash flow shocks. There is also no evidence that hospitals with an apparent
tendency to overspend on medical treatment exhibit higher sensitivities.

33
Appendix A: Investment-cash flow sensitivity in a frictionless benchmark model of a nonprofit

The appendix illustrates how investment of a nonprofit firm might respond to cash flow shocks in a
world without frictions. The example follows the altruistic view of a nonprofit, described, for example, in
Fama and Jensen (1985), Rose-Ackerman (1996), and Fisman and Hubbard (2005). Based on this view, the
objective function of the nonprofit firm is to maximize the utility of its donors or the public at large. In
the example, an altruistic donor derives utility from providing a charity good, X, to the nonprofit’s
customers. We use the term “charity good” loosely to denote any good that the donor is willing subsidize
and that requires subsidization in order to be provided. For example, subsidized education or
uncompensated healthcare services would fall in this category. Given that there are no frictions, the donor
makes an optimal donation every period, and the nonprofit maintains no endowment. The donor
consumes non-charity goods outside the nonprofit, and we denote the non-charity consumption as C.

Besides the charity good X, the nonprofit produces a good Y which generates profit V but does not
enter the donor’s utility function directly.37 For simplicity, we assume that the production functions for X
and Y are independent. Since Y has no direct effect on donor utility, the organization always chooses Y to
maximize profit because this maximizes resources available to produce X. The nonprofit’s problem is thus:

Max, , st. and 0, (1)

with U(.) and X(.) being increasing and concave, D is donation, and W is the donor’s wealth. We assume
for simplicity that the profit V is not sufficient to satisfy the donor’s demand for X, so that the donor
chooses to make a strictly positive donation. In this case, the first-order conditions to problem (1) imply
that the nonprofit produces X up to the point when the donor’s marginal utilities from charity and non-
charity consumption are equalized:

(2)

Importantly, an exogenous shock to the nonprofit’s cash flow can induce higher spending on X
because it relaxes the donor’s wealth constraint. Eq. (3) below describes this effect in more detail.
Specifically, it shows how a change in V affects the optimal level of donations, and indirectly the
production of X. Assuming that the donor’s utility is separable in X and C (i.e., UC,X = 0), one can show
that:

, (3)

37 The role of revenue generating activities in nonprofits is discussed, for example, in Rose-Ackerman (1996).

34
 ,

where , , . Since both U and X are concave, K 0, and depending on the

curvature of U, is between -1 and 0. Thus, in equilibrium, the donor reduces his donation in response to
the cash flow shock because the nonprofit has more internal resources available for production of X. The
reduction in D typically does not totally undo the cash windfall V because the donor spends some of the
windfall on an increased consumption of X.

Overall, the example highlights how for-profit and nonprofit firms respond to cash flow shocks. For
a donor-focused nonprofit, a cash flow shock relaxes the donor’s wealth constraint, and thus can lead to
more consumption and spending on X. In contrast, a for-profit firm expands production only if it is value-
maximizing to do so. Thus a cash flow shock that is unrelated to the for-profit’s investment opportunities
should never impact spending.

The example also shows under what conditions the nonprofit’s spending becomes unresponsive to
cash flows. Specifically, eq. (3) shows that when the donor’s utility is quasi-linear in non-charity
consumption C (i.e., , 0), donations decline one-for-one in response to shocks to V ( 1).

This means that cash windfalls have no impact on production of X and instead are used entirely to increase
the non-charity consumption. The quasi-linearity assumption fits well in our setting as long as charitable
giving to a particular hospital constitutes a small fraction of its typical donor’s consumption bundle. If this
is the case, one can reasonably assume that a dollar increase in a donor’s wealth would be spent primarily
on other consumption ( , in eq. 3 is close to zero), leaving the desired charitable giving to the hospital
almost unchanged. Consequently, cash flow shocks that are unrelated to investment opportunities have no
impact on nonprofit expenditures, which matches the standard result from Q-theory.

In the one-period example above, the positive cashflow shock to the nonprofit is offset by a reduction
in current donations. More generally, the nonprofit could save the extra cash for future spending (while
donors scale back future donations), and other forms of current or future subsidies to the nonprofit could
also adjust to the nonprofit’s financial condition. The example does not model the different mechanisms;
its purpose is merely to illustrate the intuition for why, in the absence of frictions, nonprofit expenditures
should be (almost) irresponsive to cash flow shocks.

35
Appendix B: Certificate of Need Laws

The appendix shows the dates of the introduction and repeal of Certificate of Need Laws by state as
of September 2011. States with CON laws affecting equipment spending are marked with an asterisk.

State or District Dates of the Program State or District Dates of the Program
Indiana 1980-1996, 1997-1999 Louisiana 1991- present
North Dakota 1971-1995 Maine* 1978- present
Pennsylvania 1979-1996 Maryland 1968- present
Arizona 1971-1985 Massachusetts* 1972- present
California 1969-1987 Michigan* 1972- present
Colorado 1973-1987 Mississippi* 1979- present
Idaho 1980-1983 Missouri* 1979- present
Kansas 1972-1985 Montana 1975- present
Minnesota 1971-1985 Nebraska 1979- present
New Mexico 1978-1983 Nevada 1971- present
South Dakota 1972-1988 New Hampshire* 1979- present
Texas 1975-1985 New Jersey 1971- present
Utah 1979-1984 New York* 1966- present
Wyoming 1977-1989 North Carolina* 1978- present
Alabama 1979-present Ohio 1975- present
Alaska* 1976-present Oklahoma 1971- present
Arkansas 1975-present Oregon 1971- present
Connecticut* 1973-present Puerto Rico 1975- present
Delaware* 1978-present Rhode Island* 1968- present
District of Columbia* 1977-present South Carolina* 1971- present
Florida 1973-present Tennessee* 1973- present
Georgia* 1979-present Vermont* 1979- present
Hawaii* 1974-present Virginia* 1973- present
Illinois 1974-present Washington 1971- present
Iowa 1977-present West Virginia* 1977- present
Kentucky* 1972-present Wisconsin 1977-1987, 1993- present

Source: National Conference of State Legislatures (www.ncsl.org/default.aspx?tabid=14373)

36
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41
Table 1

Descriptive Statistics for the main (IRS) sample, 1999-2006

The data comes from the IRS Form 990. The left panel shows descriptive statistics for hospital-years in the full sample, and the right panel shows means
for subsamples split at the median based on the size of net fixed assets or financial investments. Investment Income is income from dividends plus
interest and realized and unrealized gains and losses on investments. Net Fixed Assets is gross land, buildings and equipment minus accumulated
depreciation. Service Revenue includes all revenue from medical services and total revenue includes all operating and non-operating revenue. Operating
Income is defined as the difference between service revenue and service expenses scaled by lagged net fixed assets. Executive Compensation are the
salaries of officers and directors. Net Debt is defined as total financial debt (bonds issued and bank loans) minus cash and temporary securities.

Full Sample Means for Subsamples

Low High
Mean Med Std P5 P95 N Small Large Fin. A. Fin. A.

Investment Incomet / Net Fixed Assetst-1 0.03 0.02 0.06 -0.04 0.14 5,269 0.03 0.04 0.02 0.05
Investment Incomet / Financial Investmentst-1 0.04 0.03 0.07 -0.06 0.14 5,269 0.04 0.04 0.04 0.04
Financial Investmentst / Net Fixed Assetst 0.82 0.71 0.55 0.14 1.93 5,269 0.81 0.83 0.46 1.18
Growth in Service Revenuet 0.08 0.08 0.08 -0.03 0.20 5,269 0.08 0.08 0.08 0.08
Net Incomet / Net Fixed Assetst-1 0.09 0.09 0.15 -0.15 0.35 5,269 0.08 0.10 0.06 0.13
Operating Incomet / Net Fixed Assetst-1 0.36 0.33 0.29 -0.05 0.90 5,269 0.39 0.32 0.33 0.38
Service Revenuet (in millions) 178.4 111.0 203.3 13.2 630.2 5,269 59.60 297.6 163.3 193.7
Total Revenuet (in millions) 189.1 116.8 216.9 14.2 665.5 5,269 62.10 316.4 172.0 206.2
Net Fixed Assetst (in millions) 82.5 48.3 97.9 5.9 287.7 5,269 22.80 142.5 77.3 87.8
Growth in Net Fixed Assetst 0.04 0.02 0.18 -0.10 0.32 5,269 0.03 0.06 0.03 0.06
Growth in Executive Compensationt 0.15 0.08 0.49 -0.53 0.99 4,251 0.13 0.16 0.15 0.14
Growth in Other Salaries and Wagest 0.07 0.07 0.06 -0.04 0.17 5,095 0.06 0.07 0.06 0.07
Dividend and Interest Income (% of Inv. Income) 0.40 0.26 1.38 -0.85 1.84 5,265 0.34 0.46 0.41 0.40
Unrealized Gains and Losses (% of Inv. Income) 0.42 0.42 1.94 -1.44 2.15 5,265 0.51 0.34 0.46 0.38
Realized Gains and Losses (% of Inv. Income) 0.17 0.00 0.98 -0.69 1.32 5,265 0.15 0.19 0.15 0.20
Net Debtt / Net Fixed Assetst 0.49 0.48 0.63 -0.23 1.19 5,266 0.42 0.56 0.49 0.49
Share of Hospitals with Tax-Free Bonds 0.64 5,269 0.52 0.75 0.61 0.66

42
Table 2

Descriptive Statistics for the HCRIS Sample, 1999-2009

The data comes from HCRIS, Schedule D. Investment Income comes from the statement of revenues in
Schedule G. Net Fixed Assets are defined as gross land, buildings and equipment minus accumulated
depreciation. Equipment includes cars and trucks, major movable equipment, minor equipment and minor
nondepreciable equipment. All other variables are defined in Table 1.

Mean Med Std P5 P95 N

Investment Incomet / Net Fixed Assetst-1 0.03 0.02 0.04 0.00 0.12 8,847

Investment Incomet / Financial Investmentst-1 0.06 0.04 0.09 0.00 0.17 8,672
Financial Investmentst / Net Fixed Assetst 0.50 0.34 0.51 0.01 1.59 8,847
Growth in Service Revenuet 0.07 0.07 0.08 -0.05 0.19 8,847
Net Incomet / Net Fixed Assetst-1 0.08 0.08 0.15 -0.16 0.34 8,689
Service Revenuet (in millions) 134.7 84.1 145.2 10.8 442.6 8,847
Net Fixed Assetst (in millions) 68.0 40.3 82.7 4.3 229.9 8,847
Growth in Net Fixed Assetst 0.06 0.01 0.16 -0.09 0.36 8,847
Buildingst (in millions) 88.5 53.5 106.5 6.1 294.0 8,436
Equipmentt (in millions) 57.1 34.0 68.3 3.4 190.7 7,677
Landt (in millions) 3.5 1.2 9.1 0.0 12.6 7,721
Financial Debtt / Net Fixed Assetst 0.63 0.61 0.55 0.00 1.50 8,609

44
Table 3

Effect of Performance of Financial Investments on CAPEX

The table shows OLS regressions of growth in net fixed assets on measures of investment income and control variables for the main (IRS) sample from
1999-2006. The dependent variable is the forward looking one-year (i.e. from t to t+1) and two-year (from t to t+2) growth in net fixed assets. Investment
Incomet, Operating Incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment Income is income from dividends and
interest plus realized and unrealized gains and losses on investments. Return on Securities is investment income in year t divided by securities holdings in
year t-1. Net Fixed Assets are gross land, buildings and equipment minus accumulated depreciation. Service Revenue includes all revenue from medical
services and total revenue includes all operating and non-operating revenue. Operating Income is the difference between service revenue and service
expenses. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

Net Fixed Assets (1-Year Growth) Net Fixed Assets (2-Year Growth)
Investment Incomet 0.10 0.10 0.10 0.23 0.28 0.27
(1.99) (1.67) (2.18) (3.35) (3.35) (2.84)
Return on Securitiest 0.06 0.07 0.15 0.19
(2.47) (2.06) (2.50) (2.82)
Financial Investmentst-1 0.04 0.04 0.09 0.04 0.10 0.08 0.07 0.14 0.09 0.15
(7.48) (5.44) (6.43) (7.92) (6.76) (7.38) (6.12) (5.76) (7.24) (5.88)
Growth Service Revenuet 0.19 0.17 0.02 0.19 0.03 0.31 0.28 -0.05 0.31 -0.05
(6.96) (6.66) (0.66) (6.90) (0.69) (5.44) (4.50) (-0.60) (5.56) (-0.58)
Operating Incomet 0.07 0.07 0.15 0.07 0.15 0.14 0.13 0.30 0.14 0.30
(10.05) (10.11) (7.18) (10.11) (7.19) (7.09) (6.11) (6.78) (7.09) (6.73)
Log(Total Revenuet) 0.01 0.01 0.01 0.01 0.01 0.02 0.02 0.01 0.02 0.02
(4.42) (4.90) (0.16) (4.52) (0.19) (4.14) (3.77) (0.14) (4.16) (0.18)
Hospital Fixed Effects Y Y Y Y
State-Year Fixed Effects Y Y
Year Fixed Effects Y Y Y Y Y Y Y Y
Number of Observations 5,269 5,269 5,269 5,269 5,269 4,271 4,271 4,271 4,271 4,271
R-Squared 0.06 0.13 0.47 0.06 0.47 0.08 0.16 0.58 0.08 0.58
44
Table 4

Effect of Performance of Financial Investments on CAPEX by Type of Net Fixed Assets

The table shows OLS regressions of growth in buildings, equipment, or land on investment income and control
variables for the HCRIS sample from 1999-2009. The dependent variables are the forward looking one-year
(i.e. from t to t+1) change in (1) buildings, (2) equipment and (3) land scaled by net fixed assets. Investment
Incomet, Operating incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment
Income comes from the statement of revenues in Schedule G of the HCRIS dataset. Net Fixed Assets are gross
land, buildings and equipment minus accumulated depreciation. Equipment includes cars and trucks, major
movable equipment, minor equipment and minor nondepreciable equipment. Service Revenue includes all
revenue from medical services and total revenue includes all operating and non-operating revenue. Operating
Income is the difference between service revenue and service expenses. T-statistics are in parentheses. Standard
errors are clustered by hospital and year.

Buildings Equipment Land

Investment Incomet 0.06 0.11 0. 05 0.02 0.00 0.00
(1.17) (1.18) (2.01) (0.34) (0.20) (0.41)
Financial Investmentst-1 0.03 0.09 0.02 0.05 0.00 0.00
(7.31) (6.64) (8.34) (5.40) (3.73) (2.87)
Growth Service Revenuet 0.06 0.01 0.05 0.00 0.00 0.00
(1.92) (0.28) (2.42) (-0.11) (1.52) (-0.04)
Operating Incomet 0.04 0.08 0.02 0.04 0.00 0.00
(4.06) (4.21) (3.13) (2.38) (2.08) (1.69)
Log(Total Revenuet) 0.00 -0.04 0.00 -0.02 0.00 0.00
(1.72) (-1.07) (2.63) (-1.11) (0.42) (0.07)
Hospital Fixed Effects Y Y Y
Year Fixed Effects Y Y Y Y Y Y
Number of Observations 8,436 8,436 7,677 7,677 7,721 7,721
R-Squared 0.02 0.26 0.02 0.25 0.01 0.27

Table 5

Effect of Performance of Financial Investments on Selected Expenses

The table shows OLS regressions of selected expenses on investment income and control variables for the
main (IRS) sample from 1999-2006. The dependent variables are the growth rates in (1) compensation of
officers and directors, (2) other salaries, (3) conference expenses and (4) travel expenses in year t+1. Investment
Incomet, Operating incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment
Income is income from dividends and interest plus realized and unrealized gains and losses on investments.
Net Fixed Assets are gross land, buildings and equipment minus accumulated depreciation. Service Revenue
includes all revenue from medical services and total revenue includes all operating and nonoperating revenue.
Operating Income is the difference between service revenue and service expenses. Tstatistics are in parentheses.
Standard errors are clustered by hospital and year.

46
 Executive Other Conference Travel
Compensation Compensation Expenses Expenses
Investment Incomet 0.17 0.21 0.02 0.01 - 0.07 -0.44 0 .11 -0.03
(1.02) (0.77) (1.10) (0.29) (-0.21) (-0.89) (0.95) (-
0.16)
Financial Investmentst-1 0.00 0.00 0.00 0.00 -0.04 -0.05 0.02 0.00
(-0.37) (-0.26) (3.54) (-0.81) (-3.67) (-0.82) (1.95) (0.01)
Growth Service Revt 0.24 0.03 0.19 0.08 1.00 0.85 0.36 0.16
(2.31) (0.16) (10.56) (2.42) (3.38) (1.98) (3.17) (1.02)
Operating Incomet 0.01 0.06 0.01 0.05 -0.12 0.04 0.01 0.11
(0.31) (1.10) (4.45) (4.87) (-2.11) (0.27) (0.61) (1.91)
Log(Total Revenuet) 0.01 0.08 0.00 -0.07 0.00 -0.21 0.00 -0.17
(1.57) (0.62) (1.43) (-4.23) (-0.30) (-1.17) (-0.62) (-
1.97)
Hospital Fixed Effects Y Y Y Y
Year Fixed Effects Y Y Y Y Y Y Y Y
Number of Obs. 4,251 4,251 5,095 5,095 2,496 2,496 4,197 4,197
R-Squared 0.03 0.30 0.07 0.40 0.03 0.39 0.02 0.30
Table 6

Effect of Performance of Financial Investments on CAPEX by Level of Financing Constraints

The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the main (IRS) sample from 1999-2006. The dependent variable is the forward looking one-year
(i.e. from t to t+1) growth in net fixed assets. We use three measures of financing constraints: Financial
Investments scaled by net fixed assets; Net Debt, defined as the value of bonds outstanding and other notes
payable minus cash and temporary investments scaled by net fixed assets; and Net Debt minus Financial
Investments scaled by net fixed assets. The regressions use ranks formed using the terciles or the median of
each measure. Investment Incomet, Operating Incomet, and Financial Investmentst-1 are scaled by net fixed
assets in year t-1. Investment Income is income from dividends and interest plus realized and unrealized gains
and losses on investments. Net Fixed Assets are gross land, buildings and equipment minus accumulated
depreciation. Service Revenue includes all revenue from medical services and total revenue includes all
operating and non-operating revenue. Operating Income is the difference between service revenue and service
expenses. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

Financial Constraints Measure

Fin. Investments Net Debt Net Debt – Fin. Inv.
Investment Incomet 0.22 0.24 0.00 0.03 0.01 0.03
(1.82) (1.93) (-0.02) (0.67) (0.16) (0.56)
2nd Tercile of Constraint Measure 0.01 -0.01 0.00
(0.86) (-1.08) (0.17)
3rd Tercile of Constraint Measure 0.03 -0.01 -0.02
(2.46) (-1.61) (-2.56)
T2 * Investment Incomet -0.13 0.03 0.28

47
 (-0.76) (0.30) (3.05)
T3 * Investment Incomet -0.16 0.26 0.27
(-1.27) (2.99) (1.90)
>P50 of Constraint Measure 0.01 -0.01 -0.02
(1.42) (-2.37) (-5.21)
>P50 * Investment Incomet -0.17 0.14 0.30
(-1.11) (2.32) (2.22)
Financial Investmentst-1 0.02 0.03 0.04 0.04 0.04 0.03
(2.69) (4.00) (7.87) (7.46) (5.23) (4.87)
Growth Service Revenuet 0.19 0.19 0.19 0.19 0.19 0.19
(7.22) (7.16) (6.85) (6.86) (6.86) (6.91)
Operating Incomet 0.07 0.07 0.07 0.07 0.07 0.07
(9.78) (9.83) (9.51) (9.48) (9.68) (9.40)
Log(Total Revenuet) 0.01 0.01 0.01 0.01 0.01 0.01
(4.26) (4.35) (4.35) (4.41) (3.92) (4.30)
Year FE Y Y Y Y Y Y
Number of Observations 5,266 5,266 5,266 5,266 5,266 5,266
R-Squared 0.06 0.06 0.06 0.06 0.06 0.06
Table 7

End-of-Life Treatment Measures in Dartmouth Atlas

This table reports descriptive statistics for hospitals in the matched HCRIS-Dartmouth Atlas sample. Each
observation corresponds to one hospital. The first three measures are averages for years 2003-2007. The
Teaching Hospital status is as of the first year that a hospital is in the sample. Case Mix Index (CMI) is a
summary measure of the clinical complexity of Medicare cases treated in a hospital. Higher CMI indicates more
complex cases. The Medicare Quality Scores are provided by the Hospital Quality Alliance (HQA) and are
available on the CMS Hospital Compare website. The measures attempt to capture the extent to which a
hospital provides timely and effective treatment for a number of specific medical conditions. The National
Cancer Institute (NCI) is a dummy for hospitals that are NCI-designated Cancer Centers engaged in active
cancer research. HSA stands for “Hospital Service Area”, a geographic unit constructed by Dartmouth Atlas
using Medicare discharge data meant to capture local health care markets for hospital care. National Cancer
Institute status, Case Mix Index and Medicare Quality score are all as of 2007.

Mean Med Std P5 P95 N

Percent of Patients Seeing > 10 Physicians (last 6m of life) 0.37 0.38 0.14 0.14 0.59 1,193
Percent in Intensive Care Unit (last 6m of life) 0.04 0.03 0.02 0.01 0.08 1,358
Percent of Cancer Patients Rec. Life Sust. Int. (last 1m of life) 0.12 0.11 0.04 0.07 0.19 293
Teaching Hospital 0.32 0.00 0.47 0.00 1.00 1,837
Case Mix Index 1.36 1.31 0.26 1.01 2.00 1,482
Medicare Quality Score 93.75 94.50 3.49 87.20 98.00 831
Number of Beds per 1,000 Residents in HSA 2.65 2.48 0.93 1.52 4.00 1,466
Number of Specialists per 1,000 Residents in HSA 1.24 1.20 0.29 0.85 2.00 1,466
National Cancer Institute 0.14 0.00 0.35 0.00 1.00 514

48
Table 8

End-of-Life Treatment Intensity Measures, Hospital Quality and Financial Performance

This table reports OLS regressions of the EOL treatment intensity measures on measures of hospital quality
and financial performance. Each observation corresponds to a hospital in the matched HCRIS-Dartmouth
Atlas sample. The EOL measures are averages for years 2003-2007. The Teaching Hospital status is as of the
first year that a hospital is in the sample. Case Mix Index (CMI) is a summary measure of the clinical complexity
of Medicare cases treated in a hospital. Higher CMI indicates more complex cases. The Medicare Quality Scores
are provided by the Hospital Quality Alliance (HQA) and are available on the CMS Hospital Compare website.
The measures attempt to capture the extent to which a hospital provides timely and effective treatment for a
number of specific medical conditions. National Cancer Institute (NCI) is a dummy for hospitals that are NCI-
designated Cancer Centers engaged in active cancer research. HSA stands for “Hospital Service Area”, a
geographic unit constructed by Dartmouth Atlas using Medicare discharge data meant to capture local health
care markets for hospital care. National Cancer Institute status, Case Mix Index and Medicare Quality score are
all as of 2007. All financial variables are averages for a hospital for all years that it is in the sample.

Percent Patients Percent Patients Percent of Cancer

Seeing > 10 in Int. Care Unit Pat. Rec. Life
Physicians (6m) (6m) Sust. (1m)
Teaching Hospital 0.79 -0.37 0.21
(0.89) (-1.95) (0.38)
Case Mix Index -10.94 0.04 -0.03
(-4.53) (0.08) (-0.02)
Medicare Quality Score 0.20 -0.09 -0.10
(1.72) (-3.59) (-1.43)
Number of Beds in HSA -1.64 0.28 0.37
(-2.75) (2.23) (0.93)
Number of Specialists in HSA 11.31 0.97 1.58
(8.02) (3.24) (2.16)
Financial Investments -1.25 -0.29 -0.84
(-1.58) (-1.73) (-1.88)
Growth Service Revenue -20.68 -2.65 8.61
(-1.98) (-1.19) (1.39)
Operating Income -3.93 -0.09 -3.26
(-1.46) (-0.15) (-2.19)
Log(Service Revenue) 7.57 0.65 -1.18
(8.90) (3.61) (-2.12)
Financial Debt 2.33 0.38 0.83
(2.91) (2.22) (1.80)
National Cancer Institute 1.26
(1.92)
Number of Observations 805 807 284
R-Squared 0.25 0.08 0.13

49
 and
Table 9, Panel A

Effect of Performance of Financial Investments on CAPEX by Level of EOL Treatment Intensity The
table shows OLS regressions of growth in net fixed assets on measures of investment income control variables
for the matched HCRIS-Atlas sample from 1999-2009. The dependent variable is the forward looking one-year
(i.e. from t to t+1) growth in net fixed assets. The measures of end-of-life (EOL) treatment intensity are
averages for 2003-2007. EOL Index is constructed as follows. The sample is sorted into terciles based on each
of the first two intensity measures where the sorting is done within the sample with non-missing control
variables. The EOL index is the sum of the tercile ranks (it takes on values 2-6). Time-varying controls are the
same as Table 3. Hospital-level controls are the independent variables from Table 8. Investment Incomet is
scaled by net fixed assets in year t-1. Investment Income comes from the statement of revenues in Schedule G
of the HCRIS dataset. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

End-of-Life (EOL) Treatment Intensity Measure

Percent Patients Percent Patients in Percent Cancer
See > 10 Int. Care Unit EOL Index Pat. Rec. Life
Physicians (6m) (6m) Sust. (1 m)
Investment Inct 0.53 0.43 0.47 0.43 0.70 0.65 0.72 0.83
(2.70) (1.70) (3.57) (3.43) (2.93) (2.73) (2.36) (2.92)
EOL Measure 0.00 0.00 0.00 0.00 0.01 0.00 0.00 0.00
(1.24) (0.32) (1.31) (0.83) (1.12) (0.65) (1.52) (1.53)
Investment Inct * EOL -0.01 -0.01 -0.09 -0.07 -0.15 -0.13 -0.05 -0.06
(-2.38) (-1.02) (-3.01) (-1.81) (-2.31) (-1.84) (-2.36) (-2.70)
Time-varying Controls Y Y Y Y Y Y Y Y
Hospital-level Controls Y Y Y Y
Year FE Y Y Y Y Y Y Y Y
Number of Observations 6,457 4,492 7,045 4,502 4,505 4,477 1,624 1,592
R-Squared 0.06 0.12 0.06 0.12 0.06 0.12 0.05 0.11
Table 9, Panel B

Effect of Performance of Financial Investments on CAPEX by Level of EOL Treatment Intensity The
table shows OLS regressions of growth in net fixed assets on measures of investment income control variables
for the matched HCRIS-Atlas sample from 1999-2009. The dependent variable is the forward looking one-year
(i.e. from t to t+1) growth in net fixed assets. The EOL Index (with values 2-6) measures a hospital’s EOL
treatment intensity, with higher values indicating higher intensity. The construction of the index is described in
Panel A. T1, T2, T3 are indicators for hospitals in the low, - medium-, and high-intensity groups formed based
the EOL Index. The T1, T2, and T3 groups correspond to index values of 2-3, 4-5, and 6, respectively. In the
left panel, the regressions include all observations with available data, and investment income is interacted with
the T1 and T3 indicators. In the right panel, the sample is split into the EOL Index subsamples, and the table
shows a separate regression for each subsample. Investment income is interacted with an indicator Above

50
 and
Median Debt that equals one if the hospital’s net debt to net fixed assets ratio in year t-2 is above the sample
median. Time-varying controls are the same as Table 3. Hospital-level controls are the independent variables
from Table 8. Investment Incomet is scaled by net fixed assets in year t-1. Investment Income comes from the
statement of revenues in Schedule G of the HCRIS dataset. T-statistics are in parentheses. Standard errors are
clustered by hospital and year.

Full Sample EOL Index Subsamples

T1 T2 T3

Investment Inct 0.07 -0.09 0.15 -0.06 -0.11

(0.55) (-0.71) (1.68) (-0.43) (-0.58)
T1 EOL -0.01 -0.01
(-1.05) (-1.09)
T3 EOL 0.00 0.00
(0.14) (0.05)

Investment Inct * T1 EOL 0.27 0.30

(1.74) (2.07)

Investment Inct * T3 EOL -0.11 -0.07

(-0.42) (-0.29)
Above Median Debt 0.01 0.02 0.01 0.00
(1.02) (1.45) (1.27) (0.01)

Investment Inct * Above Median Debt 0.24 0.40 0.09 0.24

(1.67) (1.89) (0.58) (0.80)
Time-varying Controls Y Y Y Y Y
Hospital-level Controls Y Y Y Y Y
Year FE Y Y Y Y Y
Number of Observations 4,477 4,411 1,808 1,822 781
R-Squared 0.12 0.13 0.15 0.14 0.13

Table 10

Effect of Performance of Financial Investments on CAPEX: Certificate of Need Laws

The table shows OLS regressions of growth in net fixed assets on measures of investment income control
variables for the main (IRS) sample from 1999-2006. The dependent variable is the forward looking one-year
(i.e. from t to t+1) and two-year (from t to t+2) growth in net fixed assets. Investment Incomet, Operating

51
 and
Incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment Income is income
from dividends and interest plus realized and unrealized gains and losses on investments. Net Fixed Assets are
gross land, buildings and equipment minus accumulated depreciation. CON is an indicator variable equal to 1
if a state has a Certificate of Need Law in place in a year and 0 otherwise. Service Revenue includes all revenue
from medical services and total revenue includes all operating and non-operating revenue. Operating Income
is the difference between service revenue and service expenses. T-statistics are in parentheses. Standard errors
are clustered by hospital and year.

Net Fixed Assets Net Fixed Assets (2 Yrs.)

Investment Incomet 0.20 0.17 0.61 0.70
(2.29) (2.16) (4.08) (4.41)
CON 0.01 -0.10 0.02 -0.01
(2.83) (-3.49) (2.11) (-0.10)
Investment Incomet * CON -0.14 -0.10 -0.51 -0.58
(-1.93) (-1.09) (-3.70) (-3.59)
Financial Investmentst-1 0.04 0.09 0.08 0.14
(7.67) (6.45) (7.63) (5.80)
Growth Service Revenuet 0.19 0.02 0.32 -0.04
(6.86) (0.63) (5.35) (-0.49)
Operating Incomet 0.07 0.15 0.14 0.30
(10.13) (7.17) (7.08) (6.67)
Log(Total Revenuet) 0.01 0.00 0.02 0.01
(4.18) (0.14) (3.89) (0.10)
Year FE Y Y Y Y
Hospital FE Y Y
Number of Observations 5,269 5,269 4,271 4,271
R-Squared 0.06 0.47 0.08 0.58

52
Internet Appendix for “Investment Decisions of Nonprofit Firms: Evidence from Hospitals”

Table A1, Panel A

Descriptive statistics including minimum and maximum for the main (IRS) sample, 1999-2006
The data comes from the IRS Form 990. Investment Income is income from dividends plus interest and
realized and unrealized gains and losses on investments. Net Fixed Assets is gross land, buildings and
equipment minus accumulated depreciation. Service Revenue includes all revenue from medical services and
total revenue includes all operating and non-operating revenue. Operating Income is defined as the difference
between service revenue and service expenses scaled by lagged net fixed assets. Executive Compensation
reflects the salaries of officers and directors. Net Debt is defined as total financial debt (bonds issued and bank
loans) minus cash and temporary securities.

Mean Med Std Min Max N

Investment Incomet / Net Fixed Assetst-1 0.03 0.02 0.06 -0.14 0.29 5,269

Investment Incomet / Financial Investmentst-1 0.04 0.03 0.07 -0.22 0.58 5,269
Financial Investmentst / Net Fixed Assetst 0.82 0.71 0.55 0.02 2.70 5,269
Growth in Service Revenuet 0.08 0.08 0.08 -0.41 0.57 5,269
Net Incomet / Net Fixed Assetst-1 0.09 0.09 0.15 -0.36 0.59 5,269
Operating Incomet / Net Fixed Assetst-1 0.36 0.33 0.29 -0.53 1.54 5,269
Service Revenuet (in millions) 178.40 111.00 203.30 5.7 1,073.0 5,269
Total Revenuet (in millions) 189.10 116.80 216.90 6.5 1,134.8 5,269
Net Fixed Assetst (in millions) 82.50 48.30 97.90 2.2 501.8 5,269
Growth in Net Fixed Assetst 0.04 0.02 0.18 -1.00 0.83 5,269
Growth in Executive Compensationt 0.15 0.08 0.49 -1.00 3.13 4,251
Growth in Other Salaries and Wagest 0.07 0.07 0.06 -0.26 0.34 5,095
Dividend and Interest Income (% of Inv. Income) 0.40 0.26 1.38 -5.51 8.24 5,265
Unrealized Gains and Losses (% of Inv. Income) 0.42 0.42 1.94 -9.78 10.30 5,265
Realized Gains and Losses (% of Inv. Income) 0.17 0.00 0.98 -5.09 4.52 5,265
Net Debtt / Net Fixed Assetst 0.49 0.48 0.63 -3.66 16.30 5,266
Share of Hospitals with Tax-Free Bonds 0.64 5,269
Table A1, Panel B
Descriptive statistics for subsamples split based on returns on financial assets
The table shows averages of the variables used in the main tests for subsamples with return on financial assets
below and above the sample median. Return on Financial Assets is defined as Investment Incomet / Financial
Investmentst-1. We also show t-statistics for the differences between the means computed after clustering the
standard errors by hospital and year.

Returns<P50 Returns>P50 T-Stat

53
 0.763 0.836 2.0

Financial Investmentst / Net Fixed Assetst

Growth in Service Revenuet 0.081 0.082 0.0
Operating Incomet / Net Fixed Assetst-1 0.351 0.352 0.1
Service Revenuet (in millions) 150.1 187.7 3.7
Net Fixed Assetst (in millions) 70.0 88.0 3.5
Growth in Net Fixed Assetst 0.053 0.054 0.2
Growth in Executive Compensationt 0.002 0.002 0.2
Growth in Other Salaries and Wagest 0.060 0.058 -0.9
Number of Observations 1,685 1,743

54
Table A2

Robustness of Main Results To Alternative Clustering Procedures

The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the main (IRS) sample from 1999-2006. The dependent variable is the forward looking one-year
(i.e. from t to t+1, columns 1 and 2) and two-year (from t to t+2, columns 3 and 4) growth in total net fixed
assets. All regressions include the controls described in Table 3 of the main text. The first line shows the point
estimate of the effect of investment income on the growth in net fixed assets, and all other lines show standard
errors and t-statistics (in parenthesis). We show five alternative ways of constructing standard errors: 2-way
clustering by state and year, and by hospital and year (the method we use throughout the paper), and
bootstrapped one-way clustered standard errors by year, state and hospital.

Total Fixed Assets Total Fixed Assets (2-year

(1-year growth) growth)
Investment Incomet 0.097 0.099 0.2 33 0.275
Standard Errors (t-statistic)
2-way cluster: State and Year 0.057 0.038 0.081 0.105
(1.71) (2.60) (2.88) (2.61)
2-way cluster: Hospital and Year 0.049 0.045 0.069 0.097
(1.99) (2.18) (3.35) (2.84)
Cluster (Bootstrap): Year 0.048 0.058
(2.03) (4.04)
Cluster (Bootstrap): State 0.054 0.105
(1.79) (2.21)
Cluster (Bootstrap): Hospital 0.047 0.051 0.086 0.090
(2.05) (1.92) (2.70) (3.06)
Controls Y Y Y Y
Hospital Fixed Effects Y Y
Year Fixed Effects Y Y Y Y
Number of Observations 5,269 5,269 4,271 4,271

Table A3

Effect of Performance of Financial Investments on CAPEX Using HCRIS, 1999-2009

The table shows OLS regressions of growth in net fixed assets on investment income and control variables for
the HCRIS sample from 1999-2009. The dependent variables is the forward looking one-year (i.e. from t to
t+1) and two-year (from t to t+2) growth in net fixed assets. Investment incomet, operating incomet, and
financial investmentst-1 are scaled by net fixed assets in year t-1. Investment Income comes from the statement
of revenues in Schedule G of the HCRIS dataset. Net Fixed Assets are gross land, buildings and equipment
minus accumulated depreciation. Service Revenue includes all revenue from medical services and total revenue
includes all operating and non-operating revenue. Operating Income is the difference between service revenue
and service expenses. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

55
 Net Fixed Assets (1-year growth) Net Fixed Assets (2-year growth)
Investment Incomet 0.09 0.22 0.10 0.18
(1.54) (2.31) (1.05) (1.19)
Financial Investmentst-1 0.05 0.16 0.08 0.30
(8.54) (7.68) (9.87) (10.00)
Growth Service Revenuet 0.13 0.02 0.24 0.04
(3.85) (0.42) (5.00) (0.98)
Operating Incomet 0.10 0.15 0.17 0.27
(11.95) (6.75) (8.05) (7.41)
Log(Total Revenuet) 0.00 -0.04 0.01 -0.15
(1.54) (-1.14) (1.76) (-2.83)
Hospital Fixed Effects Y Y
Year Fixed Effects Y Y Y Y
Number of Observations 8,847 8,847 7,867 7,867
R-Squared 0.05 0.36 0.07 0.48

Table A4

Effect of Performance of Financial Investments on CAPEX by Level of Financing Constraints

The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the main (IRS) sample from 1999-2006. The dependent variable is the forward looking one-year
(i.e. from t to t+1) growth in net fixed assets. We use three measures of financing constraints: Financial
Investments scaled by net fixed assets; Net Debt, defined as the value of bonds outstanding and other notes
payable minus cash and temporary investments scaled by net fixed assets; and Net Debt minus Financial
Investments scaled by net fixed assets. The regressions use ranks formed using the terciles or the median of
each measure. Investment Incomet, Operating Incomet, and Financial Investmentst-1 are scaled by net fixed
assets in year t-1. Investment Income is income from dividends and interest plus realized and unrealized gains
and losses on investments. Net Fixed Assets are gross land, buildings and equipment minus accumulated
depreciation. Service Revenue includes all revenue from medical services and total revenue includes all
operating and non-operating revenue. Operating Income is the difference between service revenue and service
expenses. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

Financial Constraints Measure

Fin. Investments Net Debt Net Debt – Fin. Inv.

Investment Incomet 0.32 0.30 0.02 0.08 0.00 0.04

(1.95) (2.17) (0.25) (1.14) (0.08) (0.78)
2nd Tercile of Constraint Measure 0.04 -0.01 -0.01
(2.98) (-1.19) (-1.35)
3rd Tercile of Constraint Measure 0.10 0.02 -0.04
(4.79) (1.09) (-2.67)
T2 * Investment Incomet -0.29 0.06 0.29

56
 (-1.50) (0.37) (2.62)
T3 * Investment Incomet -0.28 0.16 0.24
(-1.51) (1.28) (1.37)
>P50 of Constraint Measure 0.05 0.01 -0.04
(3.30) (1.19) (-3.44)
>P50 * Investment Incomet -0.25 0.04 0.27
(-1.82) (0.36) (2.50)
Financial Investmentst-1 0.07 0.08 0.09 0.09 0.09 0.09
(4.16) (5.52) (6.45) (6.45) (5.79) (6.11)
Growth Service Revenuet 0.03 0.03 0.02 0.02 0.03 0.03
(0.84) (0.68) (0.55) (0.66) (0.76) (0.75)
Operating Incomet 0.14 0.14 0.16 0.15 0.15 0.15
(6.62) (6.66) (6.99) (7.05) (6.33) (6.74)
Log(Total Revenuet) 0.00 0.00 0.00 0.00 0.00 0.00
(-0.14) (0.03) (0.13) (0.15) (0.06) (0.14)
Year FE Y Y Y Y Y Y
Hospital FE Y Y Y Y Y Y
Number of Observations 5,266 5,266 5,266 5,266 5,266 5,266
R-Squared 0.48 0.47 0.47 0.47 0.47 0.47

57
Table A5

Effect of Performance of Financial Investments on CAPEX by Level of Financing Constraints, 1999-2006

The table shows OLS regressions of growth in net fixed assets on measures of investment income and control variables for the main (IRS) sample from
1999-2006. The dependent variable is the forward looking one-year (i.e. from t to t+1) growth in net fixed assets. We use three measures of financing
constraints: Financial Investments scaled by net fixed assets; Net Debt, defined as the value of bonds outstanding and other notes payable minus cash
and temporary investments scaled by net fixed assets; and Net Debt minus Financial Investments scaled by net fixed assets. The first three columns for
each measure show results for subsamples split at the terciles, and the last two columns show results for subsamples split at the median. Investment
Incomet, Operating Incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment Income is income from dividends and
interest plus realized and unrealized gains and losses on investments. Net Fixed Assets are gross land, buildings and equipment minus accumulated
depreciation. Service Revenue includes all revenue from medical services and total revenue includes all operating and non-operating revenue. Operating
Income is the difference between service revenue and service expenses. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

Financial Investments Net Debt Net Debt – Financial Investments

T1 T2 T3 <Med >Med T1 T2 T3 <Med >Med T1 T2 T3 <Med >Med

Investment Incomet 0.26 0.06 0.07 0.25 0.07 0.07 0.05 0.17 0.09 0.11 0.01 0.28 0.28 0.05 0.29
(1.70) (0.44) (0.74) (1.45) (0.71) (0.83) (0.74) (1.57) (1.63) (1.46) (0.09) (7.85) (1.64) (0.67) (2.14)

Fin. Investmentst-1 0.03 0.06 0.01 0.04 0.03 0.02 0.05 0.05 0.02 0.05 0.03 0.05 0.04 0.02 0.05
(1.71) (2.57) (0.99) (2.06) (2.91) (1.41) (12.95) (5.36) (2.94) (6.30) (3.10) (4.83) (2.61) (2.51) (3.73)
Growth Service Revt 0.17 0.24 0.17 0.19 0.19 0.19 0.15 0.21 0.17 0.20 0.18 0.20 0.18 0.15 0.22
(3.78) (4.18) (2.34) (4.91) (3.61) (3.23) (4.59) (4.06) (4.12) (7.13) (2.50) (5.25) (3.78) (2.69) (6.40)
Operating Incomet 0.08 0.07 0.07 0.08 0.07 0.07 0.06 0.08 0.08 0.07 0.08 0.05 0.08 0.07 0.08
(6.77) (3.79) (4.45) (6.43) (3.96) (6.26) (4.39) (3.37) (13.04) (4.37) (6.34) (3.15) (5.30) (5.61) (10.33)
Log(Total Revt) 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.00 0.01 0.01 0.01
(2.90) (2.45) (2.80) (1.73) (4.24) (1.77) (1.80) (3.03) (2.27) (2.91) (2.35) (0.74) (2.35) (3.61) (1.88)
Year FE Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y
N 1,736 1,794 1,736 2,637 2,629 1,736 1,794 1,736 2,636 2,630 1,736 1,794 1,736 2,632 2,634
R-Squared 0.04 0.04 0.04 0.04 0.04 0.04 0.07 0.08 0.04 0.07 0.05 0.05 0.05 0.04 0.06
 58

Table A6

Correlation Table for End-of-Life Measures

This table reports correlations of End-of-Life measures and other hospital characteristics for all hospitals in the matched HCRIS-Dartmouth Atlas sample.
Each observation corresponds to one hospital. The first three measures are averages for years 2003-2007. The Teaching Hospital status is as of the first
year that a hospital is in the sample. Case Mix Index (CMI) is a summary measure of the clinical complexity of Medicare cases treated in a hospital. Higher
CMI indicates more complex cases. The Medicare Quality Scores are provided by the Hospital Quality Alliance (HQA) and are available on the CMS
Hospital Compare website. The measures attempt to capture the extent to which a hospital provides timely and effective treatment for a number of
specific medical conditions. The National Cancer Institute (NCI) is a dummy for hospitals that are NCI-designated Cancer Centers engaged in active
cancer research. HSA stands for “Hospital Service Area”, a geographic unit constructed by Dartmouth Atlas using Medicare discharge data meant to
capture local health care markets for hospital care. National Cancer Institute status, Case Mix Index and Medicare Quality score are all as of 2007.

(1) (2) (3) (4) (5) (6) (7) (8) (9)

(1) Percent of Patients Seeing > 10 Physicians (6m) 1.00

(2) Percent Receiving in Intensive Care Unit (6m) 0.53 1.00

(3) Percent of Cancer Patients Rec. Life Sust. Int. (1m) 0.26 0.30 1.00
(4) Teaching Hospital 0.35 0.20 0.05 1.00
(5) Case Mix Index 0.36 0.21 -0.04 0.52 1.00
(6) Overall Medicare Quality Score 0.10 -0.10 -0.12 0.08 0.20 1.00
(7) Number of Beds per 1000 Residents in HSA -0.22 -0.03 0.13 -0.16 -0.28 -0.12 1.00
(8) Number of Specialists per 1,000 Residents in HSA 0.31 0.15 0.21 0.20 0.06 0.00 -0.04 1.00
(9) National Cancer Institute 0.21 0.12 0.16 0.30 0.39 0.02 0.13 0.29 1.00
59
Table A7

Economic Magnitude of the Effects Shown in Table 8

The table shows the mean of each of the four dependent variables used in Table 8 of the main text, as well as
the effect on the dependent variables of a one-standard deviation change in each of the independent variables.
Case Mix Index (CMI) is a summary measure of the clinical complexity of Medicare cases treated in a hospital.
Higher CMI indicates more complex cases. The Medicare Quality Scores are provided by the Hospital Quality
Alliance (HQA) and are available on the CMS Hospital Compare website. The measures attempt to capture the
extent to which a hospital provides timely and effective treatment for a number of specific medical conditions.
The National Cancer Institute (NCI) is a dummy for hospitals that are NCIdesignated Cancer Centers engaged
in active cancer research. HSA stands for “Hospital Service Area”, a geographic unit constructed by Dartmouth
Atlas using Medicare discharge data meant to capture local health care markets for hospital care.

Percent Patients Percent of Cancer

Seeing > 10 Phys. Percent Patients in Pat. Rec. Life Sust.
Int. Care Unit (6m) (1m)
(6m)
Mean Dependent Variable (%) 41.43 4.24 11.73

Effect of one standard deviation change in:

Case Mix Index -2.44 0.01 -0.01
Medicare Quality Score 0.67 -0.30 -0.31
Number of Beds in HSA -1.06 0.18 0.21
Number of Specialists in HSA 3.23 0.28 0.49
Financial Investments -0.60 -0.14 -0.40
Growth Service Revenue -0.80 -0.10 0.32
Operating Income -0.61 -0.01 -0.52
Log(Service Revenue) 5.05 0.44 -0.62
Financial Debt 1.10 0.18 0.39
Table A8

Effect of Performance of Financial Investments on CAPEX by EOL Measure: Inclusion of Hospital

Fixed Effects
The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the matched HCRIS-Atlas sample from 1999-2009. The dependent variable is the forward looking
one-year (i.e. from t to t+1) growth in net fixed assets. We use three measures of end-of-life treatment intensity,
and these variables are averages for 2003-2007. EOL Index combines the first two measures and its
construction is described in Table 9, Panel A. Time-varying controls are the same as Table 3. Investment
Incomet is scaled by net fixed assets in year t-1. Investment Income comes from the statement of revenues in
Schedule G of the HCRIS dataset. T-statistics are in parentheses. Standard errors are clustered by hospital and
year.

61
 End-of-Life (EOL) Treatment Intensity Measure
Percent
Percent
Patients Seeing Percent
Cancer Pat.
> 10 Patients in Int. EOL Index
Rec. Life Sust.
Physicians Care Unit (6m)
(1 m)
(6m)
Investment Inct 0.83 0.38 0.63 0.44 0.53 0.52 0.66 0.65
(2.78) (0.98) (3.12) (2.24) (1.66) (1.61) (1.34) (1.29)
EOL Measure . . . . . . . .

Investment Inct * EOL -0.02 0.00 -0.11 -0.06 -0.09 -0.08 -0.05 -0.05
(-2.48) (-0.57) (-2.60) (-1.59) (-1.15) (-1.12) (-1.21) (-1.18)
Time-Varying Controls Y Y Y Y
Hospital FE Y Y Y Y Y Y Y Y
Year FE Y Y Y Y Y Y Y Y
Number of Observations 6,457 4,492 7,045 4,502 4,505 4,477 1,624 1,592
R-Squared 0.32 0.30 0.34 0.30 0.30 0.30 0.30 0.30

Table A9

Effect of Performance of Financial Investments on CAPEX by EOL Measure: Inclusion of Financial

Debt Quartiles
The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the matched HCRIS-Atlas sample from 1999-2009. The dependent variable is the forward looking
one-year (i.e. from t to t+1) growth in net fixed assets. We use three measures of end-of-life treatment intensity,
and these variables are averages for 2003-2007. EOL Index combines the first two measures and its
construction is described in Table 9, Panel A. All regressions include quartiles for the level of financial debt.
The first column for each variable also uses the same controls as Table 3, and the second column adds all the
hospital-level controls from the cross-sectional regression in Table 8. Investment Incomet is scaled by net fixed
assets in year t-1. Investment Income comes from the statement of revenues in Schedule G of the HCRIS
dataset. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

End-of-Life (EOL) Treatment Intensity Measure

Percent Percent
Percent
Patients Patients in Int.
Cancer Pat.
Seeing > 10 EOL Index
Care Unit Rec. Life Sust.
Physicians
(1 m)
(6m) (6m)
Investment Inct 0.43 0.39 0.42 0.41 0.62 0.60 0.73 0.85

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 (2.68) (1.53) (3.48) (3.03) (2.63) (2.54) (2.29) (2.80)
EOL Measure 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
(0.39) (0.12) (0.74) (0.62) (0.52) (0.35) (1.25) (1.55)
Investment Inct * EOL -0.01 -0.01 -0.09 -0.06 -0.14 -0.12 -0.06 -0.06
(-2.11) (-0.92) (-2.74) (-1.65) (-2.12) (-1.74) (-2.39) (-2.70)
Time-varying Controls Y Y Y Y Y Y Y Y
Hospital-level Controls Y Y Y Y
Financial Debt Quartiles Y Y Y Y Y Y Y Y
Year FE Y Y Y Y Y Y Y Y
Number of Obs. 6,326 4,426 6,875 4,433 4,437 4,411 1,601 1,575
R-Squared 0.08 0.14 0.08 0.14 0.08 0.14 0.07 0.12
Table A10

Descriptive Statistics for Hospitals in CON and non-CON States, 1999-2006

This table reports means for all hospital-year observations split by whether they are located in a state that has
Certificate of Need laws in place. All hospital-level variables in the top panel are defined in Table 1. State-level
statistics are in the bottom panel.

CON Non-CON T-Stat

Investment Incomet / Net Fixed Assetst-1 0.032 0.029 -1.6
Investment Incomet / Financial Investmentst-1 0.040 0.037 -1.3
Financial Investmentst / Net Fixed Assetst 0.815 0.825 0.6
Growth in Service Revenuet 0.076 0.089 5.3
Net Incomet-1 / Net Fixed Assetst 0.088 0.103 3.1
Operating Incomet-1 / Net Fixed Assetst 0.365 0.333 -3.6
Service Revenuet 178.7 177.7 -0.2
Total Revenuet 189.5 187.9 -0.3
Net Fixed Assetst 82.0 83.9 0.6
Growth in Net Fixed Assetst 0.046 0.036 -1.8
Growth in Executive Compensationt 0.148 0.136 -0.8
Growth in Other Salaries and Wagest 0.064 0.072 4.2
Divident and Interest Income (% of Inv. Income) 0.390 0.436 1.1
Unrealized Gains and Losses (% of Inv. Income) 0.437 0.385 -0.9
Realized Gains and Losses (% of Inv. Income) 0.173 0.169 -0.2
Net Debtt / Net Fixed Assetst 0.469 0.539 3.7

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 Share of Hospitals with Tax-Free Bonds 0.627 0.666 2.7

State Level Statistics

Population (in millions) 8.55 16.01 29.7
Growth in Population 0.006 0.007 6.1
Growth in GDP 0.048 0.053 7.2
Percentage Urban Population 0.759 0.797 8.9
Percentage of Population Above 65 0.173 0.168 -9.1
Healthcare Share of GDP 0.141 0.134 -9.3
Growth in Healthcare Spending 0.072 0.072 -0.3
Healthcare Spending Per Capita 8.598 8.535 -12.0
Medicaid Share of Healthcare Spending 0.174 0.159 -10.2
Medicare Share of Healthcare Spending 0.189 0.190 1.5
HMO Penetration (Percentage of State Population) 0.189 0.250 19.6
County-Level Herfindahl Index 0.491 0.433 -5.8
County-Level Share of For-Profit Hospitals 0.055 0.111 12.3
Number of Observations 3,809 1,460
Table A11

Effect of Performance of Financial Investments on CAPEX: CON Laws Controlling for State
Characteristics
The table shows OLS regressions of growth in net fixed assets on measures of investment income and control
variables for the main (IRS) sample from 1999-2006. The dependent variable is the forward looking one-year
(i.e. from t to t+1) and two-year (from t to t+2) growth in net fixed assets. Investment Incomet, Operating
Incomet, and Financial Investmentst-1 are scaled by net fixed assets in year t-1. Investment Income is income
from dividends and interest plus realized and unrealized gains and losses on investments. Net Fixed Assets are
gross land, buildings and equipment minus accumulated depreciation. CON is an indicator variable equal to 1
if a state has a Certificate of Need Law in place in a year and 0 otherwise. Service Revenue includes all revenue
from medical services and total revenue includes all operating and non-operating revenue. Operating Income
is the difference between service revenue and service expenses. State characteristics include all state-level
statistics in Table A10. T-statistics are in parentheses. Standard errors are clustered by hospital and year.

Net Fixed Assets Net Fixed Assets (2 Years)

Investment Incomet 0.20 0.19 0.59 0.70
(2.23) (2.64) (3.37) (4.38)
CON 0.02 -0.10 0.03 -0.01
(2.56) (-3.03) (1.93) (-0.12)

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Investment Incomet * CON -0.16 -0.12 -0.50 -0.56
(-2.28) (-1.48) (-3.01) (-3.42)
Financial Investmentst-1 0.04 0.10 0.08 0.14
(6.94) (6.87) (6.25) (6.12)
Growth Service Revenuet 0.18 0.04 0.28 -0.01
(6.40) (0.91) (4.56) (-0.07)
Operating Incomet 0.07 0.15 0.13 0.28
(10.11) (7.36) (6.50) (6.70)
Log(Total Revenuet) 0.01 -0.01 0.03 -0.03
(5.16) (-0.26) (4.76) (-0.35)
Year FE Y Y Y Y
State Controls Y Y Y Y
Hospital FE Y Y
Number of Observations 5,209 5,209 4,224 4,224
R-Squared 0.07 0.48 0.09 0.59
Table A12

Effect of Performance of Financial Investments on CAPEX: Expected and Unexpected Components

This table reports regression with the dependent variable equal to the forward looking one-year (i.e. from t to
t+1) and two-year (from t to t+2) growth in total fixed assets, similar as in Table 3 in the paper. The investment
income is decomposed into its “expected” and “unexpected” components following the methodology in Rauh
(2006). It is based on the assumption that each hospital invests its financial assets in two portfolios: a diversified
fund of U.S. equities and a portfolio of treasury bonds. The weights on each portfolio are obtained from:
∗ ∗ 1 , where
RHospital Portfolio is the return on financial investments for the hospital in a given year, and RMarket and RBonds are
one-year returns on the S&P 500 and on 10-year constant maturity US government bonds, respectively in that
year. Using the estimated weights, we compute the expected return on a hospital portfolio assuming that
expected return on equities is 11.31% (average return on the S&P 500 during 1928-2010), and the expected
return on bonds is 5.28% (average return on 10-year constant maturity bonds). The unexpected return is the
difference between the actual return and the expected return. We obtain data on the market return and on the
return from bond investments from the website of Aswath Damodaran. The return data can be found at
http://www.stern.nyu.edu/~adamodar/pc/datasets/histretSP.xls. The first row for each dependent variable
reports OLS coefficients and the second row reports t-statistics. Standard errors are clustered by hospital and
year.

Net Fixed Assets (1-year growth) Net Fixed Assets (2-yr growth)
Investment Incomet (Expected) 0.07 0.13 0.13 0.30
(0.94) (1.66) (1.50) (2.08)
Investment Incomet (Unexpected) 0.12 0.09 0.30 0.27
(2.87) (1.70) (3.97) (2.53)
Financial Investmentst-1 0.04 0.09 0.09 0.14

65
 (6.73) (5.31) (7.99) (4.60)
Growth Service Revenuet 0.19 0.02 0.31 -0.05
(7.00) (0.65) (5.43) (-0.60)
Operating Incomet 0.07 0.15 0.14 0.30
(10.24) (7.17) (7.00) (6.78)
Log(Total Revenuet) 0.01 0.01 0.02 0.01
(4.47) (0.17) (4.18) (0.14)
Hospital Fixed Effects Y Y
Year Fixed Effects Y Y Y Y
Number of Observations 5,269 5,269 4,271 4,271
R-Squared 0.06 0.47 0.08 0.58

Table A13

Time-Varying Expected Returns and Investment-Cash Flow Sensitivity: Simulation

The table shows investment-cash flow sensitivity regressions for a simulated sample of 5,000 hospitals. The
hospitals allocate their financial assets into a combination of an equity portfolio and a fixed-income portfolio,
and the allocations change as a function of the hospitals’ expected asset growth. The goal of the simulation is
to explore to what extent the resulting time-varying expected returns on hospital portfolios could explain the
investment-cash flow sensitivities documented in Table 3. The key result is that in spite of the strong assumed
correlation between expected portfolio returns and asset growth, the investment-cash flow sensitivities
estimated on the simulated data are substantially smaller than those reported in Table 3. The details of the
simulation are as follows. The simulation assumes that the weight on the equity portfolio, w, is positively
associated with expected asset growth, INV, and that the relationship is given by ∗ with w being constrained
to be between zero and one. Thus, for example, in the left panel the weight changes linearly with asset growth
(from zero to one) as long as asset growth is between L=-0.01 and H=0.09, and the weight is zero or one
outside of that range. The table shows regression results for 10, 0.1 (left panel) and 6.5, 0.25 (right panel).
The return variables, asset growth, and are all normally distributed: the mean and standard deviation of are
zero and 0.3; the mean of the equity portfolio return is
0.1, and its standard deviation, R, is 0.2 or 0.25; and the mean and standard deviation of INV are 0.04 and
0.02 to match the descriptive statistics for asset growth in our sample.

10, 0.1 6.25, 0.25

0.01, 0.09 0.04, 0.12

20% 25% 20% 25%

RP 0.0093 0.0056 0.0064 0.0039
(0.0025) (0.0020) (0.0025) (0.0020)
Intercept 0.0390 0.0393 0.0393 0.0394
(0.0004) (0.0003) (0.0003) (0.0003)
N 5000 5000 5000 5000
Rsq. 0.003 0.002 0.001 0.001

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